Capital structure theory
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Capital structure theory






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Capital structure theory Capital structure theory Presentation Transcript

  • Financial Leverage and Capital Structure Policy
  • Capital Structure Theories
    • Modigliani and Miller model
    • Trade-off theory
    • Agency theory
    • Signaling theory
  • Capital Structure Effects on Value
    • The impact of capital structure on value depends upon the effect of debt on:
      • WACC
      • Feedback to FCF
  • MM entered a theoretical universe where the following conditions existed
    • No taxes
    • 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
        • Industry cyclicality
        • Fixed costs (operating leverage)
  • Investors Indifferent
    • 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
  • Trade-off Theory
    • 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.
      • Increases free cash flow by forcing efficiencies: failure risk gets managers’ attention
      • 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
  • Signaling Theory
    • 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
    • Retained earnings
    • Excess cash
    • Debt issuance
    • Stock issuance
    • 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