The impact of capital structure on value depends upon the effect of debt on:
Feedback to FCF
MM entered a theoretical universe where the following conditions existed
Capital structure has no impact on operating cash flows
No agency costs
No financial distress costs, riskless debt
No information asymmetry
Perpetual cash flows, no growth
Individuals and corporations borrow at the same rate
No transactions costs
MM Proposition 1 with Zero Taxes
The value of a firm is independent of its capital structure. Value depends solely on the level and risk of the firm’s cash flow
V U = value of unlevered firm (no debt) V L = value of levered firm (has debt) and
V L = V U = EBIT capitalized at WACC, since with zero growth reinvestment is zero; r su and r sL are the returns to the stock of an unlevered and levered firm, respectively
MM Proposition 2 with Zero Taxes
The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a risk premium which depends on the degree of financial leverage. Reductions in capital costs as a result of using more lower cost debt (r d ) are exactly offset by increases in the cost of levered equity (r sL ) due to added financial risk.
WACC depends on Business Risk
The WACC is equal to the unlevered cost of equity (r sU ) over any range of debt levels, where r sU depends on the firm’s ‘business risk’.
Business risk = Variability in EBIT
Fixed costs (operating leverage)
Investors desiring a specific level of leverage can create it by borrowing in their own portfolio
MM Conclusion: Capital structure can be viewed as irrelevant under very restrictive assumptions.
Proposition 2 equation for the levered cost of Equity For a zero-growth company with no taxes, Free Cash Flow to Equity = Net Income = EBIT – Interest Expense From Proposition 1 (1) (2) Substitute (2) into (1) This is the Proposition 2 equation
MM Proposition 2: No taxes Cost of Capital (%) Debt/Value Ratio (%) r s WACC r d r sU
MM Proposition 1 with Taxes
The value of an unlevered firm is equal to EBIT (1-T) capitalized at the cost of equity
The value of a levered firm is equal to the value of an unlevered firm of the same risk class, plus the value of the interest tax savings capitalized at the cost of debt
MM Proposition 2 with Taxes
The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a risk premium which depends on both the degree of leverage and the corporate tax rate .
MM Proposition 2 with Taxes r sL increases with leverage at a slower rate when corporate taxes are considered. The WACC continues to decline as new debt is added. Risk premium now includes (1-T)
Cost of Capital (%) Debt/Value Ratio (%) MM Proposition II: With taxes r s WACC r d (1 - T) r sU
Value of Firm, V (%) Debt V L V U MM relationship between value and debt with taxes TD V U
MM theory ignores financial distress costs , which increase as more leverage is used:
Higher debt costs, including negotiation and monitoring by creditors (MM assume constant cost)
Feedback to Free Cash Flow
Rejection of high risk but +NPV investments (under-investment)
Lost customers, suppliers, and employees
Loan covenants, which constrain growth
Investment in Capital (NOA) increases as lose trade credit
‘ Fire sales’ of assets to raise cash
Contradicts assumption of MM that capital structure doesn’t effect operating cash flows
Trade-off Theory (cont.)
Trade-off theory suggests optimal capital structure is reached at point where marginal distress costs exceed the marginal tax benefit from adding debt in the MM model.
Since these costs are only significant at high levels of debt, WACC could be relatively unaffected for many capital structures
Trade-off theory suggests these types of firms will use more debt
Strong cash flow
Low variability in cash flow
Low growth opportunities (predictable funds needs and less risk of jeopardizing growth investments)
Large size (safety and lower growth)
Marketable collateral (less service or R&D intensive)
Product not subject to ongoing maintenance/warranties, observable quality
Profitable enough to benefit from tax shelter
Debt can reduce Equity Agency Costs
Equity agency problem is that managers might:
use corporate funds for non-value maximizing purposes (perks, acquisitions, value-destroying growth)
or seek low risk due to undiversified interest in firm
Problem is most significant in large firms with diffuse stockholders where management ownership is low
Debt can reduce Equity Agency Costs (cont.)
The use of financial leverage:
Bonds free cash flow for firms generating more cash than required to fund +NPV opportunities, reducing perk consumption and value-destroying growth.
Substitute for other strategies: outside board members, stock ownership, large outside blockholders, takeover threat
Debt can reduce Equity Agency Costs (cont.)
Debtholders can serve as monitors for diffuse free-riding stockholders
However, debt agency costs will increase : negotiation, monitoring, covenants, under-investment
MM assumed that investors and managers have the same information.
Where significant information asymmetries exist, stockholders assume:
Company issues new stock when it is overvalued
Bonds are issued when stock is undervalued
Stock issues indicate lower expected FCF, unwilling to commit to increased debt service
Leverage-decreasing events signal overvalued stock, and vice versa, supported by empirical data
Signaling theory results in Pecking Order Hypothesis
Firms will choose the following sequence of funding sources to maintain financial flexibility and avoid negative signals
Evidence: profitable firms use less debt (surprise) because they can build more equity internally. Contradicts Trade-off theory which suggests high debt due to low default risk and need for tax shelters.
Maintain borrowing capacity
Summing the theories
This leaves us with:
V L = V U + tax benefit – financial distress
+ equity agency – debt agency + signaling
Capital structure decision requires judgment!
Effect on sustainable growth: willingness to increase debt allows for higher growth rate now.
Debt ratios of other firms in the industry.
Lender and rating agency attitudes (impact on bond ratings).
Other factors in setting the target capital structure