Capital Structure

Decisions
Issuing Debt and Equity
Recall
Pepsico needs to invest
$3.5B in 2015 and $6.5B in
2016.

Can the firm finance this

expansion without issuing
new debt or equity?
PEPSICO CASH FLOW STATEMENT
FORECAST
NEW FINANCING FOR PEPSICO
If Pepsico does not want to reduce its cash
holdings, it will need to raise new funds.

Suppose Pepsico will raise $5 billion in 2015.

Major choice: new debt or new equity?

ISSUING DEBT – MECHANICS
How will the financial statements change after the debt
issuance?

Suppose interest rate is 4%

New interest = 4% * 5,000 = 200

OLD INCOME STATEMENT
NEW INCOME STATEMENT
NEW CASH FLOW STATEMENT
ISSUING EQUITY – MECHANICS
How will the financial statements change after the
equity issuance?

Suppose Pepsico sells shares at $94 a share.

Pepsico will sell 5,000 / 94 = 53.191 m shares.

NEW = OLD INCOME STATEMENT
NEW CASH FLOW STATEMENT
ISSUING EQUITY – COSTS
What is the “cost” of issuing
new equity?

Number of shares outstanding

goes up by 53.191M

Pepsico profits will be divided

among larger number of shares
DEBT OR EQUITY?
We learned a tool that helps us make financial decisions

Net present value (NPV)

Issue debt when

NPV debt > NPV equity
NPV OF DEBT
Suppose Pepsico issues a 5-year bond at a 4% interest
rate.

Interest payment = 4% * $5B = $200M

NPV = + 5 – 0.2 / (1 + 4%) – 0.2 / (1 + 4%)^2 – … – 5.2 /

(1 + 4%)^5 =
NPV OF DEBT
NPV = + 5 – 0.2/(1 + 4%) – 0.2 / (1 + 4%)^2 – … – 5.2 /
(1 + 4%)^5 =

0
NPV OF DEBT – INTUITION
• If debt is fairly priced, interest rate = discount rate

• Costs of issuing debt ($200M interest) exactly

compensate for the benefits ($5B cash coming in)

• Efficient markets – if debt is not fairly priced, then the

NPV will not be zero
NPV OF EQUITY
• Benefit = 5B cash coming in

• Cost = Issuance of 53.191M new shares at $94 a share

• Current market value of equity = 138B

• Current shares outstanding = 1.468B

• What is the NPV of equity?

NPV OF EQUITY
We must think in terms of stock prices.

Remember that maximizing NPV is the same as maximizing

the stock price.

Old stock price = $94 = 138 / 1.468

New stock price = (138 + 5) / (1.468 + 0.053191 ) = $94

WHAT ABOUT THE NPV OF THE
INVESTMENT?
Pepsico is raising cash to
finance a new investment.

Why are we ignoring the

NPV of the new
investment in these
calculations?
WHAT ABOUT THE NPV OF THE
INVESTMENT?
NPV of debt = 0 + NPV of investment

NPV of equity = 0 + NPV of investment

NPV of investment does not affect debt or

equity decision if both are fairly priced
Two Misconceptions
1- DILUTION

A common argument

“Issuing new equity reduces the stock price because of

dilution. The number of shares outstanding goes up
and thus the stock price must come down.”
IS THERE DILUTION?
Stock price = Market value of equity / Shares
outstanding

Issuing equity increases the number of shares, but the

company receives cash in exchange (see Pepsico).

No dilution if equity sold at fair price

2- DOES DEBT REDUCE THE COST OF
CAPITAL?
Pepsico WACC
= 4.2% * (1 – 25%) * 19% + 5.5% * 81% = 5%
D/V = 19% (existing leverage ratio)

“The after-tax required return on debt is 3.2%, while the

required return on equity is 5.5%. So a clever CFO should
not issue equity. Debt is clearly cheaper.”
DOES DEBT REDUCE THE COST OF
CAPITAL?
Suppose that you increase leverage to 40%:

Pepsico WACC = 4.2% * (1 – 25%) * 40% + 5.5% * 60% = 4.5%

The increase in leverage reduces the cost of capital by 0.5%!

But this calculation is wrong!

A KEY RESULT: DEBT INCREASES
RISK
Pepsico WACC = 4.2% * (1 – 25%) * 40% + 5.5% * 60% =
4.5%

Will Pepsico be able to borrow at the same interest rate

(4.2%)?

Is the cost of equity still 5.5%?

MODIGLIANI AND MILLER (1961)

They showed why this

mechanical effect is an
illusion
DEBT AND THE COST OF CAPITAL
Increase in leverage will increase both the cost of debt
and the cost of equity

Company becomes riskier

WACC = rD* (1 – 25%) * 40% + rE * 60% = ?

DEBT AND SYSTEMATIC RISK
Only systematic risk affects the cost of capital

Debt increases a company’s exposure to systematic risk

High debt = high Beta

DEBT AND RISK EXAMPLE
DEBT AND RISK EXAMPLE
DEBT AND RISK SUMMARY
DEBT AND RISK CONCLUSION
Debt increases systematic
risk (Beta).

Greater losses for

shareholders in a
downturn
DEBT AND THE COST OF CAPITAL
Low debt
WACC = 4.2% * (1 – 25%) * 19% + 5.5% * 81% = 5%

High debt
WACC = rD* (1 – 25%) * 40% + rE * 60% = ?
rD and rE both will increase

End effect on WACC is not clear

THE M&M PROPOSITION
The cost of capital does not depend
on leverage.

Pepsico’s cost of capital is always

5%, irrespective of the amount of
leverage that Pepsico has.

M&M’s WACC equation

Pepsico WACC = rD * (1 – 25%) *
40% + rE * 60% = 5%
CONDITIONS FOR M&M TO HOLD
Debt and equity must be fairly priced (zero NPV).

No other frictions such as companies’ ability to deduct

interest from taxable income.

These conditions do not always hold, but M&M is still

an essential benchmark.
HOW TO SEE M&M

There is no mechanical
effect of leverage on the
cost of capital.
DOES M&M HOLD IN THE REAL
WORLD?

Let us talk a bit about

research.
HOW COULD WE TEST M&M?
Issuing debt or equity should give a zero NPV.

Remember: NPV and stock price are equivalent concepts.

So we can measure how stock prices react to issuance of debt

and equity.

M&M predicts a zero reaction.

EVENT STUDY
In an event study we examine the market’s reaction to
new information immediately after the market learns
the new information.

Eckbo and Masulis (1995) summarize the evidence on

event studies of capital structure.
EMPIRICAL EVIDENCE
Bond issuance does cause a nonreaction in stock prices
(zero change).

But issuance of new equity causes stock prices to

decline by 1.5% to 3%, on average.

Negative NPV!
WHICH TYPE OF FINANCING DO
FIRMS USE?
How does an average company finance investments in
the real world?

Event study suggests that issuing equity is negative NPV

What would you predict?

EVIDENCE FROM THE FIELD
PECKING ORDER OF FINANCING
First internal funds, then debt, then equity

Aggregate net equity issuance has been negative in

almost every year.

Companies are in fact reluctant to issue equity in

practice.
IMPORTANT EXCEPTIONS
Companies do rely on equity issuance in some cases.
Venture capital, IPOs, M&A

Small or not often enough to overturn pattern

Debt is the most important source of external

funds for most companies.
DEBT, PROFITS, AND VALUE
Let us go back to the Pepsico example.

Suppose Pepsico decides to issue $5 billion in

debt.

How will that impact the company’s profitability?

INCOME STATEMENTS
Interest payment is going
up by $200 million

Earnings decrease as a
result
DEBT AND PROFITS

Is Pepsico more or less

profitable after the debt
issuance?
DEBT AND PROFITS
OPAT = EBIT − taxes

OPAT will go up with

leverage.

So Pepsico becomes more

profitable after the debt
issuance.
DEBT AND TAXES

Debt takes money away

from the government!

Lower taxable income

WHY STOP AT $5B?
What if Pepsico issues
$20B in new debt instead?

OPAT is even higher!

OPAT AND LEVERAGE

For profitable companies

EVIDENCE FROM RESEARCH

What would this model

predict?
PREDICTIONS
Leverage ratios should be very high for profitable
companies.
They aren’t. Average ratio is 30%, even lower for profitable firms

Companies should always finance investments with debt.

They don’t. First internal funds, then debt
PERSONAL TAXES
The positive effect of debt on profits comes from
corporate taxes.

To get a full picture of how debt affects profits, we also

need to consider personal taxes.

What happens to corporate profits after they are

generated?
FOLLOWING OPAT
Before issuing debt
Pepsico’s OPAT in 2015 =
7,515

Where does this money

go?
FOLLOWING OPAT
Now we need to think about
personal taxes.

Debt investors (interest)

Equity investors (dividends)

Retained earnings
DEBT INVESTORS
They receive 1,156 in interest payments.

Interest payments are taxed at the personal income tax rate.

In the US, marginal income tax rate can be as high as 39.6%

using the current tax code.

Debt investors would receive (1 – 39.6%) * 1,156 = 698

EQUITY INVESTORS
They receive 3,617 in dividends.

In the US, the highest dividend tax is 20% using the

current tax code.

Equity investors would receive (1 – 20%) * 3,167 =

2,894
RETAINED EARNINGS
No immediate tax

Earnings will be taxed when they are distributed to equity

investors, either through dividends or share repurchases.

Let us use a 0% tax rate for now.

Company retains the entire amount 2,742 * (1 – 0%) = 2,742

PAYOFFS AFTER PERSONAL TAXES
OPAT = 7,515 = 6,334 +
1,181

Now let us reconsider how

debt affects profits.
AFTER-TAX PAYOFFS WITH HIGHER
LEVERAGE

Consider a 20B debt

issuance.

What happens to the

after-tax payoff?
AFTER-TAX PAYOFFS WITH HIGHER
LEVERAGE
Consider a 20B debt
issuance.

OPAT = 7,716 = 6,218 +

1,498
CONCLUSION
Before 20B debt issuance
OPAT = 7,515 = 6,334 + 1,181

After 20B debt issuance

OPAT = 7,716 = 6,218 + 1,498

OPAT increases, but after-tax payoff decreases with debt

INCREASING DEBT EVEN FURTHER
Zero taxes!

What is the problem with

this financial management
strategy?
CASH SHORTAGE
No profits to pay dividends

What about investments,

R&D, and other expenses?

A company in this situation

is financially distressed.
FINANCIAL DISTRESS
Financial distress will typically arise from low
profitability rather than from voluntary increases in
debt.

Company expected to be able to pay interest at the

time of debt issuance, but profits turned out to be
lower than expected
CONSEQUENCES OF FINANCIAL
DISTRESS
Suppose Pepsico faces the
following situation.

How should it respond?

CONSEQUENCES OF FINANCIAL
DISTRESS
How should Pepsico respond to financial distress?

Spend cash (if they have it)

Refinance debt to reduce interest payments
Issue equity
Cut dividends
Cut investments
COSTS OF FINANCIAL DISTRESS
Most of these options are likely to generate significant
value losses.

Refinancing at high interest rates

Issuing equity decreases stock price even more for
distressed firms
Cutting dividends also reduces stock price
Cutting NPV > 0 investments reduces stock price
COSTS OF FINANCIAL DISTRESS
Value losses that are due to high debt are called costs
of financial distress.

Bankruptcy is an extreme version of financial distress.

If all other options fail, then the company will become

insolvent.
HOW LARGE ARE THESE COSTS?
HOW LARGE ARE THESE COSTS?
Andrade and Kaplan (1995) estimate that these costs
can amount to 10% to 25% of firm value, measured one
year prior to financial distress.

How will these costs affect capital structure decisions?

DISTRESS COSTS AND LEVERAGE
Higher leverage increases the probability of financial
distress.

The higher the interest payment, the greater the chance

that profits become lower than interest.

Higher leverage increases average profits through taxes,

but it also increases the risk of financial distress.
TRADING OFF TAX BENEFITS AND
THE RISK OF DISTRESS
TRADING OFF TAX BENEFITS AND
THE RISK OF DISTRESS
TRADING OFF TAX BENEFITS AND
THE RISK OF DISTRESS
EVIDENCE FROM DATA

What does this figure look

like in the real world?
CAPITAL STRUCTURE AND VALUE
Korteweg (2010) estimates the effect of leverage on the
cost of capital and value for firms of different
characteristics.

Median firm gains 5% in value

CAPITAL STRUCTURE AND VALUE
CAPITAL STRUCTURE AND FIRM
CHARACTERISTICS
Not all firms have the same optimal leverage
Key variables
Cash flow volatility
Tangibility of assets
Size
Profitability
Market-to-book ratios
CASH FLOW VOLATILITY AND
LEVERAGE
USING THE TRADE-OFF MODEL
We do not have a good quantitative model of capital
structure.

We do not know how much lower leverage should be in

the previous figure.

But the trade-off model can still provide qualitative

guidance to practice.
USING THE TRADE-OFF MODEL
Firms with
High cash flow volatility
Low tangibility
Small size
Lower profits
High market-book

Should have less debt