Lecture 8 Capital Structure

(Chapter 16, 17)

 Capital Structure Theories

- Tradeoff theory
- Pecking order theory
- Market timing theory
 Recapitalization Decisions
 Capital Structure

 Percent of debt financing, also called (financial) leverage.

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 Financial Risk

 The extra risk that shareholders face when the firm uses
debt.

Financial risk   ROE   ROE (U )

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Example of financial risk

Sales 1,400,000
Variable Costs (800,000)
Fixed Costs (250,000)
EBIT 350,000
Interest (125,000)
EBT 225,000
Taxes (34%) (76,500)
Net Income 148,500

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Sales 1,540,000 +10%
Variable Costs (880,000)
Fixed Costs (250,000)
EBIT 410,000 +17.14%
Interest (125,000)
EBT 285,000
Taxes (34%) (96,900)
Net Income 188,100 +26.67%

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Sales 1,330,000 -5%
Variable Costs (760,000)
Fixed Costs (250,000)
EBIT 320,000 -8.57%
Interest (125,000)
EBT 195,000
Taxes (34%) (66,300)
Net Income 128,700 -13.33%

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 Trade-off Theory

 There is an optimal capital structure, target

capital structure, that trade off the benefits and
the costs of debt and maximizes the firm value.

 Miller and Modigliani (MM)

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 MM Version One: No Friction (1958)

 Changes in capital structure do not affect firm value

when financial markets are perfect. Only market
imperfections (taxes, etc.) allow for leverage to affect
firm value.

 MM perfect market assumptions:

 No taxes.
 No brokerage costs.
 No bankruptcy costs.
 Investors can borrow at the same rate as corporations.
 All investors have the same information as management about the firm’s
future investment opportunities.
 EBIT is not affected by the use of debt.
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 Proposition I:

levered firm value = unlevered firm value.

VL = VU

= (EBIT/WACC) = EBIT/ksU

where: ksU = cost of equity for an unlevered firm.

 Firm value is independent of leverage.

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 Proof with capital structure arbitrage
(see P. 611-612):

For two firms with exactly the same business characteristics and
different financial leverage levels, if they are differently valued,
investors can do capital structure arbitrage by short-selling the
stocks of the high-value firm, and using the proceeds to buy the
stocks of the low-value firm, which creates profits.

In a more realistic situation, this arbitrage would occur in a matter

of seconds. The low-value firm’s price is pushed up and the high-
value firm’s price is lowered down, eventually reaching an
equilibrium with two firms equally valued.

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 Proposition II:

ksL = ksU + Risk premium

= ksU +(ksU - kd)(D/S)

where: ksU = cost of equity for an unlevered firm,

ksL= cost of equity for a levered firm,
D = market value of firm’s debt,
S = market value of firm’s equity,
kd = cost of risk-free debt.

 As a firm increases its use of debt, its cost of equity

also increases; but its WACC remains constant.

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 MM Version Two: with Corporate Taxes

 Because interest is a tax-deductible expense for

corporations, a levered firm should be more valuable
than an unlevered firm (assuming that this difference
in capital structure is the only difference).

 Proposition I:

VL = VU + TD

where: T = firm’s tax rate, D = value of debt.

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 Proposition II:

ksL = ksU + (ksU - kd)(1-T)(D/S)

where: S = value of equity.

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 MM Version Three: with Multiple Frictions
 Taxes: mentioned earlier (in MM Version Two).

 Bankruptcy cost: direct costs (such as legal costs)

and indirect costs (such as reputation loss and
financial distress).

 Agency problems: [e.g.] risk-shifting  firm may

increase risk and thereby extract value from existing
bondholders. (Covenants could reduce the problems)

 Free cash flow reduction: debt might reduce extra

cash in the firms hence alleviate management
deviations. 14
 Proposition I:

VL = VU
+ TD
- (PV of bankruptcy costs)
- (PV of agency costs)
+(PV of free cash flow reduction)

 The optimal capital structure is determined by a

trade off between benefits and costs of debt.

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[Example] Suppose Titan Photo has no growth, and its
expected EBIT is $100,000, corporate tax rate is 30%. It
uses $500,000 of 12% debt financing, and the cost of equity
to an unlevered firm in the same business risk level is 16%.

1) What is the value of the firm according to MM with tax?

S = (EBIT – kd D)(1-T)/ksL
VU = SU =EBIT (1-T) / ksU
= 100000 * (1-30%) /0.16 = 437500
VL = VU+ TD = 437500 + 0.3 * 500000 = 587500
SL = VL– D = 587500 – 500000 = 87500

2) What is this firm’s cost of equity?

ksL = ksU + (ksU -kL) (1-T) (D/S)
= 16% + (16%-12%) (1-30%) (500000/87500)
= 32% 16
 Pecking Order Theory

Stewart Myers (1984)

 Managers are better informed than investors.

Investors might see an external equity issuance
a bad news about the company, assuming that
managers want outside shareholders to share
the loss, thus investors will react to this
issuance negatively, increasing the issuance
cost of external equity.
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 Firms therefore prioritize their sources of
financing according to the law of least effort, or
of least resistance: internal funds are used first,
and when that is depleted, debt is issued, and
when it is not sensible to issue any more debt,
equity is issued.
 This theory maintains that businesses adhere to a
hierarchy of financing sources and prefer internal
financing when available, and debt is preferred
over equity if external financing is required.

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 Market Timing Theory

 A firm will issue a type of external capitals when

the associated capital market is good. For
instance, it will issue stocks when the stock
market is hot.

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Other Issues Need to be Considered in Practice

 Business Risk: firms with low BR may use more debt.

 Assets: firms with marketable fixed assets may use more

debt.

 Growth: rapid growth often requires external financing, and

will typically use more debt.

 Debt Ratings: Some firms want to use more debt than their
lenders may be willing to provide. Banks and rating
agencies (S&P) use the financial ratios (TIE and other debt
ratios) for their decisions.

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 Recapitalization

Ways to recapitalize (that is, to change the

existing capital structure, equity structure, or
debt structure):

- Raising new equity: such as raising VC, IPO, SEO;

- Raising new debt/bond;
- Stock repurchase;
- Leveraged buyout, etc.

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 Recapitalization
[Example]
PPC has total mkt value = $100M, with 1M shares at $50 per
share, and $50M of 10% perpetual bonds selling at par.
EBIT = $13.24, and Tc = 15%.

PPC can change its capital structure by increasing debt to $70M

or decreasing it to $30M. If it increases leverage, it will call its old
bonds and issue new ones with a 12% coupon. If it decreases
leverage, it will call the old bonds and issue new ones with a 8%
coupon. PPC will sell or repurchase stock at the new equilibrium
price to complete the CS change. It pays all earnings as dividends and
is thus a 0% growth stock. If it increases leverage ks will be 16%, if it
decreases leverage ks will be 13%.

 Should the firm change its capital structure? 22

 Solution: base situation (D = $50M)

V = Firm Value = D + E
= Value of Debt + Value of Equity.

= $50 + $50 = $100 million .

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 Solution: Two scenarios
[EBIT - D (k d ) ] (1 - T)
V= D +
ks

Decrease leverage (to D = $30M).

($13.24 - $2.4)(0.85)
V = $30 +
0.13
= $30 + $70.88 = $100.88 million .

Increase leverage (to D = $70M).

V = $70 +
 $13.24 - $8.4 (0.85)
0.16
= $70 + $25.71 = $95.71 million .
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 Managing Capital Structure
Firms may set target (desired) capital structures by:
 setting up financial statement forecasts several years into
the future,
 explicitly including the AFN lines in the forecasts, and
 varying the proportions of new debt and equity used to
finance future growth, and
 varying the dividend payout (additional cash back to
shareholders means that more funds will be needed in the
future), repurchase of equity and type of debt (some debt
has higher interest costs).

 With such forecasts, managers are able to understand

how different scenarios affect firm value.
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