AC4331 Topic 6

Corporate Financial Policy Semester A 2012-13 City University of Hong Kong

Topic 7

Introduction to Financial Management Free Cash Flow Financial Planning and Forecasting Financial Assets and Time Value of Money Risk and Return Bond and Stock Valuation Cost of Capital Cash Flow Estimation and Risk Analysis Capital Structure and Leverage Treasury and Valuation Enterprise Risk Management Dividends and Share Repurchase Merger and Acquisitions Working Capital Management

1-2

Topic 7: Capital Structure and Leverage

Extra Ref:
Smart,Chapter 13
Brigham

Financial Management, Theory and Practice, 12e Eugene and

Chapter 15

Business vs. Financial Risk Optimal Capital Structure Operating Leverage Capital Structure Theory

15-4

Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?
Probability Low risk

High risk

Note that business risk does not include 0 E(EBIT) EBIT financing effects.

15-5

Uncertainty about demand (sales) Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage

15-6

Operating leverage is the use of fixed costs rather than variable costs. If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

15-7

More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
$ Rev. $ TC Rev.

} Profit
TC FC

What happens if variable costs change? QBE QBE Sales Sales

FC

15-8

Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.
Probability Low operating leverage High operating leverage

EBITL

EBITH

15-9

Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.

15-10

Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued.
More debt, more financial risk. Concentrates business risk on stockholders.

15-11

Two firms with the same operating leverage, business risk, and probability distribution of EBIT. Only differ with respect to their use of debt (capital structure).
Firm L $10,000 of 12% debt $20,000 in assets 40% tax rate

Firm U No debt $20,000 in assets 40% tax rate

15-12

Probability EBIT Interest EBT Taxes (40%) NI

Bad 0.25 $2,000 0 $2,000 800 $1,200

Economy Average 0.50 $3,000 0 $3,000 1,200 $1,800

Good 0.25 $4,000 0 $4,000 1,600 $2,400

15-13

Probability* EBIT* Interest EBT Taxes (40%) NI

*Same as for Firm U.

Bad 0.25 $2,000 1,200 $ 800 320 $ 480

Economy Average 0.50 $3,000 1,200 $1,800 720 $1,080

Good 0.25 $4,000 1,200 $2,800 1,120 $1,680

15-14

Firm U BEP ROE TIE Firm L BEP ROE TIE

Bad 10.0% 6.0 Bad 10.0% 4.8 1.67

Average 15.0% 9.0 Average 15.0% 10.8 2.50x

Good 20.0% 12.0 Good 20.0% 16.8 3.30x

15-15

Expected values: E(BEP) E(ROE) E(TIE) Risk measures: ROE CVROE Firm U 2.12% 0.24 Firm L 4.24% 0.39 Firm U 15.0% 9.0% Firm L 15.0% 10.8% 2.5

15-16

For leverage to raise expected ROE, must have BEP > rd. Why? If rd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, but interest expense increases (Int Exp = rdD).

15-17

Basic earning power (BEP) is unaffected by financial leverage.

L has higher expected ROE because BEP > rd.

L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

15-18

The capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. Trades off higher E(ROE) and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debts riskrelated costs. The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital.
15-19

Firm announces the recapitalization. New debt is issued. Proceeds are used to repurchase stock.
The number of shares repurchased is equal to the amount of debt issued divided by price per share.

15-20

Amount Borrowed $ 0
250 500 750

D/A Ratio 0
0.125 0.250 0.375

D/E Ratio 0
0.143 0.333 0.600

Bond Rating -AA A BBB

rd -8.0% 9.0% 11.5%

1,000

0.500

1.000

BB

14.0%

15-21

As the firm borrows more money, the firm increases its financial risk causing the firms bond rating to decrease, and its cost of debt to increase.

15-22

D $0 EPS (EBIT rdD)(1 T) Shares outstanding ($400,000)(0.6) 80,000 $3.00

15-23

$250,000 Shares repurchased 10,000 $25 (EBIT rdD)(1 T) EPS Shares outstanding ($400,000 0.08($250,000))(0.6) 80,000 10,000 $3.26 EBIT $400,000 TIE 20x Int Exp $20,000
15-24

Shares repurchased

$500,000 20,000 $25

(EBIT rdD)(1 T) EPS Shares outstanding ($400,000 0.09($500,000))(0.6) 80,000 20,000 $3.55 EBIT $400,000 TIE 8.9x Int Exp $45,000
15-25

Shares repurchased

$750,000 30,000 $25

EPS

(EBIT rdD)(1 T) Shares outstanding ($400,000 0.115($750,000))(0.6) 80,000 30,000 $3.77

EBIT $400,000 TIE 4.6x Int Exp $86,250

15-26

Shares repurchased

$1,000,000 40,000 $25

(EBIT rdD)(1 T) EPS Shares outstanding ($400,000 0.14($1,000,000))(0.6) 80,000 40,000 $3.90 TIE EBIT $400,000 2.9x Int Exp $140,000
15-27

0 D1 EPS DPS P rs g rs rs

If all earnings are paid out as dividends, E(g) = 0.

EPS = DPS.

To find the expected stock price ( ), P0 we must find the appropriate rs at each of the debt levels discussed.

15-28

If the level of debt increases, the firms risk increases. We have already observed the increase in the cost of debt. However, the risk of the firms equity also increases, resulting in a higher rs.

15-29

Because the increased use of debt causes both the costs of debt and equity to increase, we need to estimate the new cost of equity. The Hamada equation attempts to quantify the increased cost of equity due to financial leverage. Uses the firms unlevered beta, which represents the firms business risk as if it had no debt.

15-30

bL = bU[1 + (1 T)(D/E)]

Suppose, the risk-free rate is 6%, as is the market risk premium. The unlevered beta of the firm is 1.0. We were previously told that total assets were $2,000,000.

***** Important
15-31

If D = $250,
bL = 1.0[1 + (0.6)($250/$1,750)] = 1.0857 rs = rRF + (rM rRF)bL = 6.0% + (6.0%)1.0857 = 12.51%

15-32

Amount Borrowed $ 0
250 500 750

D/A Ratio 0%
12.50 25.00 37.50

D/E Ratio 0%
14.29 33.33 60.00

Levered Beta 1.00

1.09 1.20 1.36

rs 12.00% 12.51 13.20 14.16

1,000

50.00

100.00

1.60

15.60

15-33

15-34

The firms optimal capital structure can be determined two ways:

Minimizes WACC. Maximizes stock price.

Both methods yield the same results.

15-35

36

Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets:
Perfect competition Firms and investors can borrow/lend at the same rate Equal access to all relevant information No transaction costs No taxes

37

Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300 Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3.0% 11.3% 19.7%
We are buying 40 shares of a $50 stock, using $800 in margin. We get the same ROE as if we bought into a levered firm. Our personal debt-equity ratio is:

B $800 2 3 S $1,200

38

EPS of Levered Firm $1.50 $5.67

RecessionExpected Expansion

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

$9.83
$236 $64 $300 15%

Buying 24 shares of an otherwise identical levered firm along with some of the firms debt gets us to the ROE of the unlevered firm. This is the fundamental insight of M&M

39

We can create a levered or unlevered position by adjusting the trading in our own account. This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm: VL = VU

40

Proposition 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 debt S is the value of equity

41

The derivation is straightforward:

RW ACC B S RB RS BS BS

Then set RWACC R0

B S RB RS R0 BS BS

BS multiply both sides by S

BS B BS S BS RB RS R0 S BS S BS S
B BS RB RS R0 S S

B B RB RS R0 R0 S S

B RS R0 ( R0 RB ) S
42

Cost of capital: R (%)

RS R0

B ( R0 RB ) S

R0

RW ACC

B S RB RS BS BS
RB

RB

Debt-to-equity Ratio B S

43

Proposition I (with Corporate Taxes)

Firm value increases with leverage

Proposition II (with Corporate Taxes)

Some of the increase in equity risk and return is offset by the interest tax shield RS = R0 + (B/S)(1-tC)(R0 - RB)
RB is the interest rate (cost of debt) RS is the return on equity (cost of equity) R0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of equity

V L = VU + t C B

44

The total cash flow to all stakeholde rs is ( EBIT RB B) (1 tC ) RB B

The present value of this stream of cash flows is VL

Clearly ( EBIT RB B) (1 tC ) RB B EBIT (1 tC ) RB B (1 tC ) RB B EBIT (1 tC ) RB B RB Bt C RB B

The present value of the first term is VU

The present value of the second term is tCB

VL VU tC B

45

Start with M&M Proposition I with taxes:

Since

VL VU tC B

VL S B S B VU tC B
VU S B(1 tC )

The cash flows from each side of the balance sheet must equal:

SRS BRB VU R0 tC BRB

SRS BRB [S B(1 tC )]R0 tC RB B

Divide both sides by S

B B B RB [1 (1 tC )]R0 tC RB S S S B Which quickly reduces to RS R0 (1 tC ) ( R0 RB ) S RS

46

Cost of capital: R (%)

RS R0 RS R0

B ( R0 RB ) S B (1 tC ) ( R0 RB ) S

R0

S B RW ACC RB (1 tC ) RS BS BS
RB

Debt-to-equity ratio (B/S)

47

All Equity

EBIT Interest EBT Taxes (tc = 35%) Total Cash Flow to S/H

Recession $1,000 0 $1,000 $350 $650

Expected $2,000 0 $2,000 $700 $1,300

Expansion $3,000 0 $3,000 $1,050 $1,950

Recession EBIT $1,000 Interest ($800 @ 8% ) 640 EBT $360 Taxes (tc = 35%) $126 Total Cash Flow $234+640 (to both S/H & B/H): $874 EBIT(1-tc)+tCRBB $650+$224 $874

Expected $2,000 640 $1,360 $476 $884+$640 $1,524 $1,300+$224 $1,524

Expansion $3,000 640 $2,360 $826 $1,534+$640 $2,174 $1,950+$224 $2,174

Levered

48

All-equity firm
S G

Levered firm
S G

The levered firm pays less in taxes than does the all-equity firm.

Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie larger. -the government takes a smaller slice of the pie!

49

In a world of no taxes, the value of the firm is unaffected by capital structure. This is M&M Proposition I: VL = VU Proposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders. B

RS R0

( R0 RB )

50

In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage. This is M&M Proposition I: Proposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of taxes, M&M Proposition II states that leverage increases the risk and return to B stockholders.

VL = V U + t C B

RS R0

(1 tC ) ( R0 RB )

51

Life Corporation has 7 million shares of ordinary equity outstanding, 1 million shares of 6 percent preferred stock outstanding and 100,000 9 percent semi-annual bonds outstanding, par value $1,000 each. Current market value of stock is $35 per share and its beta is 1.0, the preferred stock currently sells at $60 per share, and the bond has 15 years to maturity and is currently selling for $890. The market risk premium is 8%, T-bills are yielding 3 %, and the companys tax rate is 16%. (i)Find the market value capital structure of the firm (ii)If the firm is evaluating a project that has same risk as the firms existing projects, what rate should the firm use to discount the projects future cash flows? If the project has higher risk than the firms existing projects, what should the firm do in order to evaluate the project?
52

53

Trading Off Debts Benefits and Costs

The optimal capital structure occurs where the marginal benefit of additional debt is equal to the marginal cost. How do managers trade-off the benefits and costs of debt to establish a target capital structure that maximizes firm value?

54

Figure 1 Weighing Debts Benefits and Costs to Find Optimal Capital Structure
A manager facing these cost and benefit curves would choose a debt level where the two curves intersect.

55

Figure 2 Weighing Debts Benefits and Costs to Find Optimal Capital Structure
If a firm has no debt, its value equals Vu. From there, if the firm adds debt to its capital structure, its value begins to rise, reaches a peak, and from there, adding more debt decreases firm value.

56

Figure 3 Weighing Debts Benefits and Costs to Find Optimal Capital Structure
Managers want to find the debt ratio that minimizes the cost of capital because it maximizes firm value. The optimum point in Panel C is the same optimum debt ratio as in Panels A & B.

57

Amount D/A Borrowed Ratio $ 0 0%

250 500 750 12.50 25.00 37.50

E/A Ratio rs rd(1 T) WACC 100% 12.00% -12.00%

87.50 75.00 62.50 12.51 13.20 14.16 4.80% 5.40% 6.90% 11.55 11.25 11.44

1,000

50.00

50.00

15.60

8.40%

12.00

15-58

Amount Borrowed $ 0
250 500 750

DPS $3.00 3.26 3.55 3.77

rs 12.00% 12.51 13.20 14.16

P0 $25.00 26.03 26.89 26.59

1,000

3.90

15.60

25.00

15-59

Maximum EPS = $3.90 at D = $1,000,000, and D/A = 50%. (Remember DPS = EPS because payout = 100%.) Risk is too high at D/A = 50%.

15-60

P0 is maximized ($26.89) at D/A = $500,000/$2,000,000 = 25%, so optimal D/A = 25%. EPS is maximized at 50%, but primary interest is stock price, not E(EPS). The example shows that we can push up E(EPS) by using more debt, but the risk resulting from increased leverage more than offsets the benefit of higher E(EPS).

15-61

15-62

If there were higher business risk, then the probability of financial distress would be greater at any debt level, and the optimal capital structure would be one that had less debt. However, lower business risk would lead to an optimal capital structure with more debt.

15-63

1.Sales stability? 2.High operating leverage? 3.Increase in the corporate tax rate? 4.Increase in the personal tax rate? 5.Increase in bankruptcy costs? 6.Management spending lots of money on lavish perks?

15-64

Value of Stock

MM result

Actual
No leverage 0 D1 D2
15-65

D/A

Example: PV of Tax Debt Shield

66

Debt Tax Shields and Firm Profitability

Interest deductions only lower taxes to the extent that the firm is profitable.
Using more debt financing increases the probability that the firm will experience losses.

67

Costs of Bankruptcy and Financial Distress

Bankruptcy costs are distinct from the decline in firm value that leads to financial distress. Poor management, unfavorable movements in input and output prices, and recessions can push a firm into bankruptcy, but they are not examples of bankruptcy costs. Bankruptcy costs refer to direct and

indirect costs of the bankruptcy process itself.

68

Bankruptcy Costs
It is not the event of going bankrupt that matters; it is the costs of going bankrupt that matter. If ownership of the firms assets were transferred costlessly to its creditors in the event of bankruptcy

The optimal capital structure would still be 100% debt.

When the firm incurs costs in bankruptcy that it would otherwise avoid, bankruptcy costs become a deterrent to using leverage.
69

Example
Assume if firm goes bankrupt, $10 million in assets are lost in the process of transferring ownership from stockholders to bondholders:
Firm 1
Market value of assets Debt

Firm 2 $30,000,000 $100,000,000 $0 $50,000,000 $30,000,000 $50,000,000

$40,000,000 $100,000,000 $0 $40,000,000 $100,000,000

Equity

When the recession hits, Firm 1 has $40 million in assets, but Firm 2 has $30 million in assets. Firm 2 will calculate the tax advantage of debt and weigh that against the cost of bankruptcy times the probability of bankruptcy at each debt level.

We are now looking not at bankruptcy costs per se, but at expected bankruptcy costs.
70

Bankruptcy Costs
Direct Costs
Costs of bankruptcy-related litigation (e.g. legal, auditing, and administrative costs)

Cost of management time diverted to bankruptcy process

Loss of customers who dont want to deal with a distressed firm

Indirect Costs

Loss of employees who switch to healthier firms Strained relationships with suppliers Lost investment opportunities
71

Bankruptcy Costs
Indirect costs are likely to be much larger, and are likely to vary a great deal depending on the type of firm in distress. Indirect costs may be high: When the firms product requires that the firm stay in business (e.g., when warranties or service are important) When the firm must make additional investments in product quality to maintain customers For example, think of customers worrying that a bankrupt airline might try to save $ by cutting spending on safety.
72

VL = VU + PV(Tax shields) PV(Bankruptcy costs)

73

Producers of complex products or services tend to use less debt than do firms producing nondurable goods or basic services. Companies whose assets are mostly tangible and have well-established secondary markets should be less fearful of financial distress than companies whose assets are mostly intangible.

74

75

Jensen and Meckling (1976): agency cost theory of financial structure Agency costs of outside equity

Managers who own less than 100% of the firm have an incentive to expropriate wealth from the firms investors.
Excessive perquisite consumption Less effort devoted to increasing firms value

76

77

Using debt means a firm can sell less external equity and still finance its operations. Using debt reduces managerial perquisite consumption. External debt serves as a bonding mechanism. Debt subjects managers to direct monitoring by public capital markets.

78

Agency Costs of Outside Debt

Bondholders begin taking on an increasing fraction of the firms risk as firms use more debt. Shareholders and managers still control the firms investment and operating decisions, so managers have incentives to transfer wealth from bondholders to themselves and other shareholders.
For example, managers might sell bonds and then pay a huge dividend to shareholders, leaving bondholders with an empty corporate shell.
79

Agency Costs of Outside Debt

Asset substitution (bait and switch)
Underinvestment

Problems with outside debt

Bondholders protect themselves with positive and negative covenants in lending contracts.
Agency costs of debt are burdensome, but so are solutions.

80

Agency Costs of Outside Debt

Asset substitution is the promise to invest in a safe asset to obtain an interest rate reflecting low risk, and then substituting a riskier asset promising a higher expected return. Underinvestment occurs when a firms shareholders refuse to invest in a positiveNPV project because most of the benefits would be realized by bondholders.

81

Smart Figure 13.5 The Trade-off Model Revisited

VL = VU + PV(Tax shields) PV(Bankruptcy costs) PV(Agency costs)

82

Implications of the Trade-off Model

Profitable firms should borrow more than unprofitable firms because they are more likely to benefit from interest tax shields. Firms that own tangible, marketable assets should borrow more than firms whose assets are intangible or highly specialized. Safer firms should borrow more than riskier firms. Companies should have a target debt ratio.
83

Some studies find that the most profitable firms in an industry have the lowest debt ratios. Leverage-increasing events, such as stock repurchases and debt-for-equity exchange offers, almost always increase stock prices, while leverage-decreasing events reduce stock prices. Firms issue debt securities frequently, but seasoned equity issues (equity issues from firms that already have stock) are rare.
84

85

The graph shows MMs tax benefit vs. bankruptcy cost theory. Logical, but doesnt tell whole capital structure story. Main problem--assumes investors have same information as managers.

15-86

Signaling theory suggests firms should use less debt than MM suggest. This unused debt capacity helps avoid stock sales, which depress stock price because of signaling effects.

15-87

Assumptions:
Managers have better information about a firms long-run value than outside investors. Managers act in the best interests of current stockholders.

What can managers be expected to do?

Issue stock if they think stock is overvalued. Issue debt if they think stock is undervalued. As a result, investors view a stock offering negativelymanagers think stock is overvalued.

15-88

Issue stock if they think stock is overvalued. Issue debt if they think stock is undervalued. As a result, investors view a common stock offering as a negative signalmanagers think stock is overvalued.

15-89

Intuitively appealing model, but relatively little empirical support Leverage ratios are, if anything, negatively related to profitability in almost every industry. Asset-rich companies use far more debt than do growth companies with intangible assets.

Signaling models predict a positive relationship!!!

Information asymmetry is more severe for growth companies, which thus should have a greater need to signal.
90

Smart Figure 13.5 The Trade-off Model Revisited

VL = VU + PV(Tax shields) PV(Bankruptcy costs) PV(Agency costs)

91

92

Dividend policy is sticky. Firms prefer internal financing (retained earnings and depreciation) to external financing of any sort, debt or equity. If a firm must obtain external financing, it will issue the safest security first. As a firm requires more external financing, it will work down the pecking order of securities:
1. 2. 3. 4. 5. Safe debt Risky debt Convertible securities Preferred stock Common stock (as a last resort)
93

Assumptions

Manager acts in best interests of existing shareholders. Information asymmetry between managers and investors.

Two key predictions about managerial behavior

Firms hold financial slack so they dont have to issue securities.

Firms follow pecking order when issuing securities: sell low-risk debt first, equity only as last resort.
94

It implies that firms have no target capital structure and that the debt ratios observed in the real world ought to fluctuate randomly.

95

96

Taxes

Types of Assets

Since interest is tax deductible, highly profitable firms should use more debt (i.e., greater tax benefit). The costs of financial distress depend on the types of assets the firm has.

Uncertainty of Operating Income

Pecking Order and Financial Slack

Even without debt, firms with uncertain operating income have a high probability of experiencing financial distress. Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.

15-97

Trading Off Debts Benefits and Costs

The optimal capital structure occurs where the marginal benefit of additional debt is equal to the marginal cost. How do managers trade-off the benefits and costs of debt to establish a target capital structure that maximizes firm value?

98

Smart Figure 13.5 The Trade-off Model Revisited

VL = VU + PV(Tax shields) PV(Bankruptcy costs) PV(Agency costs)

99

Most corporations have low Debt-Asset ratios. Changes in financial leverage affect firm value.
Stock price increases with increases in leverage and viceversa; this is consistent with M&M with taxes. Another interpretation is that firms signal good news when they lever up.

There are differences in capital structure across industries. There is evidence that firms behave as if they had a target Debt-Equity ratio. As more debt is added and the probability of losses increases, the marginal benefit of debt curve slopes downward.

38

10 1

102

What Companies Do Globally

Smart Figure 13.6 Target Capital Structure

103

10 4

Smart Figure 13.5 The Trade-off Model Revisited

VL = VU + PV(Tax shields) PV(Bankruptcy costs) PV(Agency costs)

10 5

Need to make calculations as we did, but should also recognize inputs are guesstimates. As a result of imprecise numbers, capital structure decisions have a large judgmental content. We end up with capital structures varying widely among firms, even similar ones in same industry.

15-106

Eugene Chapter 15 Self-test Questions and Problems, ST-1,2,3 Questions: 15-3, 15-6, 15-7, 15-11 Problems: 15-1,15-2,15-3, 15-6,15-8, 1510,15-11 Comprehensive Question: 15-14

10 7