capital structure decisions professor artur raviv kellogg school of management

Capital Structure Decisions 1

Capital Structure Decisions

Professor Artur Raviv

Kellogg School of Management


Capital Structure decisions

Discussion Agenda

A. What is Financial Leverage

B. Effects of Leverage

C. Optimal Financing in Perfect Markets

D. Optimal Financing in Imperfect Markets


What is Financial Leverage

All-equity Firm

A firm that uses only equity to finance operations is called an all equity or an unleveraged firm.Equity Value Debt Value Firm Value

E V=


What is Financial Leverage

Leveraged Firm

A firm that uses sources of financing other then equity, typically debt, has financial leverage and is called a leveraged firm.

Firm ValueEquity Value Debt Value

D + E V=


Effects of Leverage

Four important effects of financial leverage:1. Increases expected rates of return on equity and

expected EPS

2. Increases risk of equity: both variance and beta

3. Increases the probability of bankruptcy and expected bankruptcy costs

4. Increases the interest tax shieldWhich effect is positive (improves shareholders welfare)

and which is negative (reduces shareholders welfare)?


Effects of Leverage

1. Leverage Increases Expected Rates of Returns on Equity and Expected EPS.

Example Consider $100 (all-equity) investment in a house.

Expected return on the house is rEu = 15%.

Expected Net Income is = 15%$100 = $15. To find EPSU, suppose there are “10 $10 shares

outstanding”. Thus, EPSU = $15/10 = $1.5.


Effects of Leverage

Consider the following Financial EngineeringBorrow (take a mortgage) $90 and invest only $10 in own equity. The borrowing rate is the risk-free rate, rD = 10%. (Now there is only “one $10 share outstanding”.) Expected return to leveraged equity and EPS,

both go up .

Alternatively:

E

Drrrr

r

DUE

UE

LE

LE

)(

%6010

90%)10%15(%15

6$1

6$,%60

10

90%1015

goutstandinshareone

IncomeNetExpectedEPS

InvestmentEquity

IncomeNetExpectedr L

LE


Effects of Leverage

2. Leverage Increases Risk: Both Variance and Beta.

So far the example looked at expected return of 15%. Suppose the underlying distribution is

30%

0%

.5

.5


Effects of Leverage

Variability of equity returns in unleveraged firm: In “bad” state equity return is 0%. In “good” state equity return is 30%

Equity returns in unleveraged firm are ± 15% around the mean of 15%.

We have here ”double (to 30%) or nothing (to 0%).”


Effects of Leverage

Variability of equity returns in Leveraged firm: In “bad” state cash flow to equityholders equal $100 -

$9 - $90 = $1. On $10 investment this gives a return of -90%.

In “good” state cash flow to equityholders equals $130 - $9 - $90 = $31. On $10 investment this gives a return of 210%.

Equity returns in leveraged firm are ± 150% around the mean of 60%.

Volatility far exceeds the ”double or nothing” situation of the unleveraged firm.


Effects of Leverage

3. Leverage Increases the Probability of Bankruptcy and Expected Bankruptcy Costs.

Probability of Bankruptcy =Probability (EBIT < Interest)

It increases with leverage because interest is increased and EBIT remains the same.


Effects of Leverage

Bankruptcy Costs Bankruptcy costs = the difference between the

value of the assets before and after bankruptcy. The magnitude of bankruptcy costs depends on the

nature of the firm and its industry. Firms with tangible assets have lower bankruptcy costs than

firms whose assets are intangible. Even absent formal bankruptcy, there are costs of

financial distress. These costs increase with the level of debt.


Effects of Leverage

4. Leverage Increases the Interest Tax Shield. Interest payments on corporate debt are

deductible from taxable income. Therefore, debt provides a tax shield for corporations.


Effects of Leverage:Summary

Leverage Increases

1. Equity rate of return and EPS

2. Equity risk

3. Expected bankruptcy cost

4. Tax shields

Impact on Shareholders

1. Positive

2. Negative

3. Negative

4. Positive

The question of optimal leverage is highly controversial. To gain understanding, we start with an idealized world, perfect capital markets.


Capital Structure Under Perfect Capital Markets - M&M

Perfect Capital Markets are Defined: no taxes; no bankruptcy costs; no transaction costs (buying, selling or issuing

securities); equal access to the markets (information, size,

etc..); price taking.



M&M Proposition 1 Under perfect capital markets capital structure is

irrelevant to firm value the value of the firm is unchanged when proportions of

debt and equity are changed.

VL = VU

Debtlevel

Leveraged Firm value, VL

VU VL



IntuitionSince production decisions are fixed, the total cash flow is unchanged. Different capital structures have different ways of

splitting the same total.

Firm Value Equity Value Debt Value Equity Value Debt Value

$100

$50$50

$80

$20



Conclusion Since firm value does not change with degree of

leverage and since debt is sold in competitive markets for its fair value, equityholders situation is not affected by leverage.

The first two effects of leverage are a perfect wash: The increase in expected return to equity just compensates shareholders for the increased risk.


Capital Structure Under Imperfect Capital Markets

Tax Consideration - Debt Provides Tax Shield VL= VU + PV of tax shields

• Consider a firm with perpetual debt level D that pays annual interest rate rD.

• Annual interest payment equals rDD

• Annual tax shield equals TrDD

• PV of tax shield equals TrDD/rD = TD

D

VL

VU

VL = Vu + TD

VL = Vu + TD



IntuitionAs debt increases, the government share of the given pie decreases. The figures below assume pre-tax value of $100; thus,

with T = 34%, VU = $66 (first figure on left).Shareholders Government

Debtholders

$34

$66

Shareholders Debtholders

Government

$50

$17$33


Government

$80

$7

$13VU = $66 VL = $50 + $33 =

$83

VL = $80 + $13.2 = $93.2



Expected Bankruptcy Costs (EBC)VL= VU + PV of tax shields - EBC

D

VL

VU

VL = Vu + TD

VL = Vu + TD - EBC

D*

VL*



With bankruptcy costs, as debt levels increase the expected value lost due to expected bankruptcy cost increases.

Shareholders Government

Debtholders EBC

$10

$59


Government EBC

$30

$20 $42


Government EBC

$60$14

$10

$31

$8$16

Riskless Debt Risky Debt Riskier Debt



Firms within an industry tend to have similar debt levels. Different industries tend to have different debt levels.

Examples: In 1981 Chrysler restructured by mainly giving debtholders

equity. Makes sense, given that Chrysler had heavy losses accumulated, so their effective TD was basically zero.

Real-Estate companies tend to use extensive leverage. Makes sense, given that expected bankruptcy cost is very low.

What is the capital structure of McKinsey? Why?



Agency Costs Conflict Between Shareholders and Managers

a) Debt increases the fraction of equity held by managersb) Debt commits the firm to pay out “free cash”. This prevents

“empire building” but may result in under- investment. Conflict Between Debtholders and Equityholders

a) Equityholders may benefit from “going for broke- ”asset substitution.”

b) Equityholders may refuse to contribute additional funds even if the firm has a positive NPV project because the benefits accrue to debtholders - “debt overhang” problem.



Asymmetric Information Capital markets underprice equity issuance since

they view the firm as issuing equity when it is overpriced. This results in “pecking order” theory - issue new securities in order of increasing sensitivity to market valuation (risk free debt, risky debt, convertible debt, and equity as last resort)

Firms issuing debt signal that they are of high quality.



Product/ Input Market Interactions Increase in leverage gives incentive to equityholders to

pursue riskier more aggressive strategies. Also, to avoid bankruptcy, they are pushed toward strategies that generate early cash.

Predation - More highly leveraged firms might be easier predation targets.

Interaction with customers/ suppliers - more debt affects these interactions since customers and suppliers bear the costs of bankruptcy.



Corporate Control Capital structure affects the outcome of takeover

contests and their likelihood through its effect on the distribution of votes. It will affect the fraction of votes owned by large “insiders”.

Debt contracts give various level of control to debtholders (covenants could be very restrictive).


Capital Structure under Imperfect Capital Markets

Personal Taxation The firm tries to minimize PV of all taxes,

not just corporate. On the personal level, equity has a more favorable treatment than debt thus, offsetting part of debt’s corporate tax advantage.


Summary of two-day announcement effects associated with exchange offers, security sales with designated uses of funds, and calls of convertible securities. With sources and uses of funds associated, these transactions represent virtually pure financial structure changes.

Type of Transaction Security Issued

Security Retired

Average Sample

Size

Two-Day Announcement Period Return

LEVERAGE-INCREASING TRANSACTIONS

Stock Repurchase Exchange Offer Exchange Offer Exchange Offer Exchange Offer

Debt Debt

Preferred Debt

Income bonds

Common Common Common Preferred Preferred

45 52 9

24 24

21.9% 14.0 8.3 2.2 2.2

TRANSACTIONS WITH NO CHANGE IN LEVERAGE

Exchange Offer Security Sale

Debt Debt

Debt Debt

36 83

0.6* 0.2*

LEVERAGE-REDUCING TRANSACTIONS

Conversion-Forcing Call Conversion-Forcing Call Security Sale Exchange Offer Exchange Offer Security Sale Exchange Offer

Common Common

Convertible debt Common Preferred Common Common

Convertible preferred Convertible bond

Debt Preferred

Debt Debt Debt

57 113 15 30 9

12 20

-0.4* -2.1 -2.4 -2.6 -7.7 -4.2 -9.9

*Not statistically different from zero. Source: C. W. Smith, "Investment Banking and the Capital Acquisition Process," Journal of Financial Economics, 1986, p. 12.

capital structure decisions professor artur raviv kellogg school of management

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