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Chapter 16: Capital Chapter 16: Capital StructureStructure

Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley

ObjectiveTo understand how a firm can

create value through itscapital structure

decisions

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Chapter 16 ContentsChapter 16 Contents• 16.1 Internal Verses External Financing16.1 Internal Verses External Financing

• 16.2 Equity Financing16.2 Equity Financing

• 16.3 Debt Financing16.3 Debt Financing

• 16.4 The Irrelevance of Capital Structure in a 16.4 The Irrelevance of Capital Structure in a Frictionless EnvironmentFrictionless Environment

• 16.5 Creating Value Through Financing Decisions16.5 Creating Value Through Financing Decisions

• 16.6 Reducing Costs16.6 Reducing Costs

• 16.7 Dealing with Conflicts of Interest16.7 Dealing with Conflicts of Interest

• Weighted Average Cost of CapitalWeighted Average Cost of Capital

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IntroductionIntroduction

– The basic unit of analysis of this chapter is The basic unit of analysis of this chapter is the firm as a wholethe firm as a whole

– We examine how a corporation’s We examine how a corporation’s management should make decisions management should make decisions regarding the mix of debt and equityregarding the mix of debt and equity

– We start with Modigliani and Miller’s We start with Modigliani and Miller’s model of a firm in a frictionless model of a firm in a frictionless environment with no tax and cost-free environment with no tax and cost-free contract compliance, and later re-contract compliance, and later re-introduce frictionsintroduce frictions

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16.1 Internal Verses 16.1 Internal Verses External FinancingExternal Financing

• Internal financingInternal financing– sources of funds that arise from the sources of funds that arise from the

operation of the firm, and includes operation of the firm, and includes retained earnings, increases in accrued retained earnings, increases in accrued wages and accounts payablewages and accounts payable

– External fundingExternal funding

– sources of funds from outside lenders sources of funds from outside lenders and investors, and includes the and investors, and includes the proceeds of bond and equity issuesproceeds of bond and equity issues

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Internal Verses External Internal Verses External FinancingFinancing• Decision ProcessDecision Process

– Financing decisions for an established Financing decisions for an established firm (not undertaking a major expansion) firm (not undertaking a major expansion) are routine and almost automatic, and are routine and almost automatic, and may consist of a dividend policy, and may consist of a dividend policy, and maintaining a bank’s line of creditmaintaining a bank’s line of credit

– Tapping outside resources is time-Tapping outside resources is time-consuming for management because of consuming for management because of the need to satisfy statutory and the need to satisfy statutory and skeptical investor demands, but it does skeptical investor demands, but it does expose the company’s plans to market expose the company’s plans to market disciplinediscipline

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16.2 Equity Financing16.2 Equity Financing

• There are three kinds of equity There are three kinds of equity claims on a company:claims on a company:– Common stock/sharesCommon stock/shares

– Corporate Stock options/WarrantsCorporate Stock options/Warrants

– Preferred stockPreferred stock

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Common stock/sharesCommon stock/shares

• The residual claims to the The residual claims to the corporation’s assetscorporation’s assets

• May be divided intoMay be divided into• Voting stockVoting stock

• Non-voting stockNon-voting stock

• Restricted or Founders stockRestricted or Founders stock

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Corporate Stock options/ Corporate Stock options/ WarrantsWarrants

• Options issued Options issued by the firmby the firm

– Used to attract and compensate key Used to attract and compensate key employees and management in employees and management in corporate startups corporate startups

– Used to ‘sweeten’ the bonds of risky Used to ‘sweeten’ the bonds of risky venturesventures

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Preferred stockPreferred stock

• A bond-like security that normally A bond-like security that normally cannot trigger a default for non-cannot trigger a default for non-payment of dividend payment of dividend

• Unlike bonds, it has a dividend that Unlike bonds, it has a dividend that is is notnot an expense for tax purposes an expense for tax purposes

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16.3 Debt Financing16.3 Debt Financing

• Corporate Debt is a contractual Corporate Debt is a contractual obligation of the part of the obligation of the part of the organization to make future organization to make future payments in return for resources payments in return for resources provided to it. It includes:provided to it. It includes:

• loans and debt securities, such as loans and debt securities, such as bonds and mortgagesbonds and mortgages

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• We now describe We now describe – secured debtsecured debt

– long-term leaseslong-term leases

– pension liabilitiespension liabilities

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Secured DebtSecured Debt

• An asset pledged as security for a An asset pledged as security for a debt is called debt is called collateralcollateral, and the , and the debt is said to be debt is said to be securedsecured

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Secured DebtSecured Debt– Should a company with secured debt Should a company with secured debt

become insolvent, then the secured become insolvent, then the secured bondholders are paid from the proceeds of bondholders are paid from the proceeds of the sale of the collateralthe sale of the collateral

– Any money remaining from the sale of the Any money remaining from the sale of the collateral is added to the pool used to pay collateral is added to the pool used to pay other creditors: IRS, employee wages, other creditors: IRS, employee wages, debenture holders, trade creditors, et cetera debenture holders, trade creditors, et cetera

– If the proceeds are inadequate, then the If the proceeds are inadequate, then the shortfall becomes a general liability, and is shortfall becomes a general liability, and is paid after payment to the IRS, and wagespaid after payment to the IRS, and wages

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Long-Term LeasesLong-Term Leases

– Leasing an asset for a period of time that is Leasing an asset for a period of time that is long compared to the asset’s useful life is long compared to the asset’s useful life is similar to buying the asset, and financing similar to buying the asset, and financing the purchase with debt secured by the the purchase with debt secured by the leased assetsleased assets

– The main difference is in who bears the risk The main difference is in who bears the risk associated with the residual market value associated with the residual market value at the end of the term of the leaseat the end of the term of the lease

– A secondary difference may occur if the lessor is A secondary difference may occur if the lessor is unable to fully utilize the depreciation tax shelterunable to fully utilize the depreciation tax shelter

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Pension LiabilitiesPension Liabilities– Pension funds are eitherPension funds are either

• defined contributiondefined contribution

• defined benefitdefined benefit

– Some pension plans are Some pension plans are fundedfunded, and some are , and some are unfundedunfunded• Some jurisdictions require that pension plans are Some jurisdictions require that pension plans are

funded, and/or are disclosed in financial statements, funded, and/or are disclosed in financial statements, others do notothers do not

– Pension fund liability is often substantialPension fund liability is often substantial• resolving precisely what a company’s pension fund resolving precisely what a company’s pension fund

liabilities are is often critical when determining capital liabilities are is often critical when determining capital structurestructure

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16.4 The Irrelevance of 16.4 The Irrelevance of Capital Structure in a Capital Structure in a Frictionless EnvironmentFrictionless Environment• Modigliani and Miller:Modigliani and Miller:

• In an economist’s idealized world of In an economist’s idealized world of frictionless marketsfrictionless markets– the total market value of all securities the total market value of all securities

issued by a firm issued by a firm • is governed by the earning power and risk is governed by the earning power and risk

of its underlying real assets, of its underlying real assets,

• and is and is independentindependent of the of the mixmix of securities of securities issued to finance the firmissued to finance the firm

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Frictionless Environment Frictionless Environment AssumptionsAssumptions

– no income taxesno income taxes

– no transaction costs of issuing no transaction costs of issuing debt/equitiesdebt/equities

– investors and management have same investors and management have same informationinformation

– stakeholders are able to resolve stakeholders are able to resolve conflicts costlesslyconflicts costlessly

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ExampleExample

• Nodett Nodett – Dividends = Earnings = EBIT (no tax, Dividends = Earnings = EBIT (no tax,

no interest)no interest)

– Common StockCommon Stock• Market Value = $100 millionMarket Value = $100 million

• dividends = $10 million/yeardividends = $10 million/year

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ExampleExample

• Somdett (otherwise identical to Nodett)Somdett (otherwise identical to Nodett)– dividends = EBIT - Interest dividends = EBIT - Interest

– Perpetual bonds Perpetual bonds • market value= $40 millionmarket value= $40 million

• coupon 3.2 million/year (risk-free, see later)coupon 3.2 million/year (risk-free, see later)

– Common StockCommon Stock• Market Value = $100 - $40 = $60 millionMarket Value = $100 - $40 = $60 million

• dividends = $10 - $3.2 = $6.8 million/yeardividends = $10 - $3.2 = $6.8 million/year

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ExampleExample

– The probabilities of EBIT (shown later) are The probabilities of EBIT (shown later) are such that the debt is risk-free, but the such that the debt is risk-free, but the stock has riskstock has risk

– The contingent claims chapter showed The contingent claims chapter showed that we could evaluate common stock by that we could evaluate common stock by subtracting the (risk-free) bond value subtracting the (risk-free) bond value from the value of the company as a wholefrom the value of the company as a whole

– M&M follows from contingent claims M&M follows from contingent claims theory, which follows from the Law of One theory, which follows from the Law of One PricePrice

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ExampleExample

– Let us see what happens if EBIT is volatile, Let us see what happens if EBIT is volatile, with discrete values of $5, $10, and $15 with discrete values of $5, $10, and $15 million (each with probability = 33.33%)million (each with probability = 33.33%)

– The total dividends of Nodett will be $5, The total dividends of Nodett will be $5, $10, and $15 million$10, and $15 million

– The total dividends of Somdett will be The total dividends of Somdett will be $1.8, $6.8, and $11.8 million $1.8, $6.8, and $11.8 million • (note that, given the facts, the interest will (note that, given the facts, the interest will

always be paid: the bondholders are always be paid: the bondholders are riskless)riskless)

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ExampleExample

– The expected dividends areThe expected dividends are• Nodett $10 millionNodett $10 million

• Somdett $6.8 million Somdett $6.8 million – (the same values as in the case of no (the same values as in the case of no

volatility, results from the distribution)volatility, results from the distribution)

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Example ConclusionExample Conclusion• If Nodett were to issue $40 million of If Nodett were to issue $40 million of

debt, and repurchase 400,000 shares debt, and repurchase 400,000 shares at $100 each, the value of the at $100 each, the value of the outstanding shares would remain outstanding shares would remain unchanged at $(100,000,000 - unchanged at $(100,000,000 - 40,000,000)/(1,000,000 - 400,000) = 40,000,000)/(1,000,000 - 400,000) = $100 each$100 each

• If the debt was not, in fact, risk-free, If the debt was not, in fact, risk-free, then the analysis will become a little then the analysis will become a little more complex, but the essential more complex, but the essential conclusions are unchangedconclusions are unchanged

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16.5 Creating Value 16.5 Creating Value Through Financing Through Financing DecisionsDecisions

• We now take a step in the direction We now take a step in the direction of greater realism. The trade-off is of greater realism. The trade-off is generally between:generally between:– tax benefits of increasing debt, and tax benefits of increasing debt, and

– financial distress costs of increasing financial distress costs of increasing debtdebt

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16.6 Reducing Costs16.6 Reducing Costs

• Optimal capital structure seeks to Optimal capital structure seeks to minimize the sum of the taxes paid minimize the sum of the taxes paid to the govt. and the costs of to the govt. and the costs of financial distress financial distress

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ExampleExample

• Reconsider Nodett and Somdett, Reconsider Nodett and Somdett, this time in a world where there is a this time in a world where there is a 34% tax on earnings after interest, 34% tax on earnings after interest, and no personal income taxesand no personal income taxes

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Claimant ClassesClaimant Classes

Nodett Somdett

1 Creditors No Yes

2 Government Yes Yes

3 Shareholders Yes Yes

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Leverage (Gearing) Leverage (Gearing) EquationsEquations

0.34*InterestCFCF

34% Tax_Rate

Tax_Rate*InterestCF

Tax_Rate*Interest Tax_Rate *EBIT

Interest Tax_Rate)-(1 *Interest) -(EBIT

Interest EarningsNet CF

NodettSomdett

Nodett

Somdett

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Maximization of Somdett’s Maximization of Somdett’s Cash FlowCash Flow

• The cash flows above are the combined The cash flows above are the combined flows to the shareholders & stockholdersflows to the shareholders & stockholders– The greater the annual interest payment, the The greater the annual interest payment, the

greater the combined cash flow, and the greater the combined cash flow, and the greater the value of the firm as a wholegreater the value of the firm as a whole

• The Market Value of Somdett = Market The Market Value of Somdett = Market Value of Nodett + PV Interest Tax ShieldValue of Nodett + PV Interest Tax Shield

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Maximization of Somdett’s Maximization of Somdett’s Cash FlowCash Flow

• Earlier, we showed that the $40 Earlier, we showed that the $40 million debt issue at 8% was risk-million debt issue at 8% was risk-free, given the distribution of free, given the distribution of earningsearnings

• The market values of claims is then The market values of claims is then given in the next table:given in the next table:

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Market Values of ClaimsMarket Values of Claims

Claimant Nodett Somdett

CreditorsShareholdersGovernment

$0.0 million$66.0 million$34.0 million

$40.0 million$39.6 million$20.4 million

Total $100.0 million $100.0 million

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Value of Tax ShieldValue of Tax Shield

– The value of the tax shield is the loss of The value of the tax shield is the loss of value to the government of issuing value to the government of issuing bonds, $(34.0-20.4) million = $13.6 bonds, $(34.0-20.4) million = $13.6 million = value of bonds * Tax ratemillion = value of bonds * Tax rate

– Recall from before, we converted Recall from before, we converted Nodett into an image of Somdett by Nodett into an image of Somdett by purchasing shares and issuing $40 purchasing shares and issuing $40 million of bondsmillion of bonds

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Value of Tax ShieldValue of Tax Shield

– Directly after the announcement, the share Directly after the announcement, the share price will rise from $66 to $(66+13.6) = price will rise from $66 to $(66+13.6) = $79.6 each$79.6 each

– The company would repurchase $40 million / The company would repurchase $40 million / $79.6 = 502,513 shares, leaving 497,487 $79.6 = 502,513 shares, leaving 497,487 outstandingoutstanding

– Sellers will be subject to an additional capital Sellers will be subject to an additional capital gain of $13.6/share, and holders to an gain of $13.6/share, and holders to an unrealized capital gain of the same amountunrealized capital gain of the same amount

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Reducing Costs: Financial Reducing Costs: Financial DistressDistress

• Let’s look at a firm where there is a Let’s look at a firm where there is a probability of financial distressprobability of financial distress– Financial distress: the imminent Financial distress: the imminent

danger of defaulting on debtdanger of defaulting on debt

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Stock Price and Leverage(Real Estate Project with High Bankruptcy Costs)

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

0% 20% 40% 60% 80% 100%

Debt Ratio

Sto

ck P

rice

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16.7 Dealing with 16.7 Dealing with Conflicts of Interest: ‘Free Conflicts of Interest: ‘Free Cash Flow’Cash Flow’

• Having debt outstanding reduces Having debt outstanding reduces the ‘free cash flow’ and this makes the ‘free cash flow’ and this makes managers more accountable to the managers more accountable to the marketmarket– The need for new financing occurs The need for new financing occurs

more frequently, making managers more frequently, making managers less likely to invest in projects that less likely to invest in projects that increase their power, prestige or perksincrease their power, prestige or perks

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Increasing RisksIncreasing Risks– Management (acting in the interests of Management (acting in the interests of

shareholders) may increase total risk at shareholders) may increase total risk at the expense of total value of the firmthe expense of total value of the firm• Badpenny currently has bonds and stock Badpenny currently has bonds and stock

outstanding, each with a market value of $50 outstanding, each with a market value of $50 million, and has assets invested in short-term T-million, and has assets invested in short-term T-billsbills

• Management enters into a project with Capone Management enters into a project with Capone Enterprises in which an unfair coin (with a Enterprises in which an unfair coin (with a probability 60% heads) is tossed in the airprobability 60% heads) is tossed in the air

• If a ‘tail’ shows, Capone Industries will double If a ‘tail’ shows, Capone Industries will double Badpenny’s investment in T-bills, otherwise, Badpenny’s investment in T-bills, otherwise, Capone takes all Badpenny’s T-billsCapone takes all Badpenny’s T-bills

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Badpenny (Continued)Badpenny (Continued)

– If Badpenny is unlucky, its bonds and If Badpenny is unlucky, its bonds and stock will be worth nothingstock will be worth nothing

– If Badpenny is lucky, its bonds retain the If Badpenny is lucky, its bonds retain the original value, but the stock price will original value, but the stock price will tripletriple• The expected wealth of Badpenny’s bond holders is The expected wealth of Badpenny’s bond holders is

$(1-0.60)*50 million = $20 million$(1-0.60)*50 million = $20 million

• The expected wealth of the stockholders is $(1-The expected wealth of the stockholders is $(1-0.60)*(200-50) million = $60 million0.60)*(200-50) million = $60 million

• New expected value of the firm = $80 millionNew expected value of the firm = $80 million

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Weighted Average Cost of Weighted Average Cost of CapitalCapital

• The cost of capital depends upon its The cost of capital depends upon its useuse not its not its sourcesource– A firm’s cost of equity is the A firm’s cost of equity is the

• expected rate of return investors require on expected rate of return investors require on an investment in a firm’s common stockan investment in a firm’s common stock

– A firm’s weighted average cost of capital A firm’s weighted average cost of capital (WACC) is the (WACC) is the • discount rate used in computing a firm’s discount rate used in computing a firm’s

value from its future cash flowsvalue from its future cash flows

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The Firm’s Weighted-The Firm’s Weighted-Average Cost of CapitalAverage Cost of Capital

– As a practical matter, determining the As a practical matter, determining the cost of capital of a company with cost of capital of a company with transaction costs is quite difficult, and transaction costs is quite difficult, and involves optimizing the timing of new involves optimizing the timing of new debt and equity issuesdebt and equity issues

– Assuming a M&M economy, the Assuming a M&M economy, the following equations apply:following equations apply:

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M&M EquationsM&M Equations

firm theof uemarket val E D V

equity sfirm' theof uemarket val E

debt sfirm' a of uemarket val D

interest of rate free-risk ther

leverageut equity w/o ofcost thek

)(

ED

Dr

ED

EkWACC

rkE

Dkk

e

e