Capital structure

1. CAPITAL STRUCTURE DECISIONS
LECTURE TWO

2. • What are the observed patterns (empirical evidence) on debt-to-
equity?
• How well do the various theories explain the empirical evidence?
• What factors (variables) are considered (should be considered) in
capital structure decisions?

3. Introduction
• Sources of long term capital
• Equity: residual claimants
• Ordinary shares (common stock)
• Retained earnings
• Treasury shares
• Preference shares
• Preferential dividends and repayments
• Debt
• Servicing obligations: interests, principal and premiums
• Loans, bonds & leases

4. • Seniority
• Collateral
• Callability
• Positive and negative covenants
• Credit ratings
• Internationalisation
• Eurobond: single currency debt issued in several countries
• Foreign bond: raised by a non-resident in another country (eg.yankee, Heidi & sumarai
foreign bonds)

5. Key choices in long term financing decisions
• How much capital should be raised and when?
• How much should be raised internally and externally?
• How much should be raised directly through financial
intermediaries and how much from issuing securities?
• What proportion of external funding is/should be structured
as ordinary shares, preference shares and debt?

6. Empirical evidence on capital structure
1. Industry patterns on capital structure (proportions) transcends national boundaries
2. Capital structure (decisions made) vary across countries
3. Leverage is inversely related to the perceived cost of financial distress
4. Leverage varies inversely with profitability
5. Tax matters but is not the only factor explaining the differences in leverage within and between
industries and countries
6. Increasing leverage and decreasing leverage have a positive and negative impact on
shareholders wealth respectively (all things being equal)
7. Firms pursue a target leverage/gearing ratio

7. 1. The trade off model
2. The pecking order hypothesis
3. The signalling model
4. The managerial opportunism (market-timing) hypothesis

8. • In a perfect capital
market, capital
structure does not
impact a firm’s
value.
8
Do Firms Have Target Capital Structures?

9. • The optimal capital structure occurs where the marginal
benefit of additional debt is equal to the marginal cost.
• How do managers trade-off the benefits and costs of debt to
establish a target capital structure that maximizes firm value?
9
Trading Off Debt’s Benefits and Costs
A manager facing these cost and
benefit curves would choose a debt
level where the two curves intersect.

10. 10
Weighing Debt’s Benefits and Costs to Find
Optimal Capital Structure
If a firm has no debt, its value equals Vu.
From there, if the firm adds debt to its
capital structure, its value begins to rise,
reaches a peak, and from there, adding
more debt decreases firm value.

11. 11
Weighing Debt’s Benefits and Costs to Find
Optimal Capital Structure
Managers want to find the debt ratio that
minimizes the cost of capital because it
maximizes firm value. The optimum point in
Panel C is the same optimum debt ratio as
in Panels A & B.

12. 12
Example: PV of Tax Debt Shield

13. • Interest deductions only lower taxes to the extent
that the firm is profitable.
• Using more debt financing increases the probability
that the firm will experience losses.
13
Debt Tax Shields and Firm
Profitability

14. • Bankruptcy costs are distinct from the decline in firm
value that leads to financial distress.
• Poor management, unfavorable movements in input
and output prices, and recessions can push a firm
into bankruptcy, but they are not examples of
bankruptcy costs.
• Bankruptcy costs refer to direct and indirect costs of
the bankruptcy process itself.
14
Costs of Bankruptcy and Financial Distress

15. 15
It is not the event of going bankrupt that matters; it is the
costs of going bankrupt that matter.
If ownership of the firm’s assets were transferred costlessly
to its creditors in the event of bankruptcy…
The optimal capital structure would still be 100% debt.
When the firm incurs costs in bankruptcy that it would otherwise
avoid, bankruptcy costs become a deterrent to using leverage.
Bankruptcy Costs

16. 16
Direct Costs
Costs of bankruptcy-related litigation (e.g.
legal, auditing, and administrative costs)
Indirect
Costs
Cost of management time diverted to
bankruptcy process
Loss of customers who don’t want to deal with
a distressed firm
Loss of employees who switch to healthier firms
Strained relationships with suppliers
Lost investment opportunities
Bankruptcy Costs

17. 17
Indirect costs are likely to be much larger, and are likely to
vary a great deal depending on the type of firm in distress.
Indirect costs may be high:
When the firm’s product requires that the firm stay in
business (e.g., when warranties or service are important)
When the firm must make additional investments in product
quality to maintain customers
For example, think of customers worrying that a bankrupt
airline might try to save $ by cutting spending on safety.
Bankruptcy Costs

18. The Trade-off Model of Capital Structure (incorporating taxes
and bankruptcy costs)
18
VL = VU + PV(Tax shields) – PV(Bankruptcy costs)

19. • Producers of complex products or services tend to
use less debt than do firms producing nondurable
goods or basic services.
• Companies whose assets are mostly tangible and
have well-established secondary markets should be
less fearful of financial distress than companies
whose assets are mostly intangible.
19
Asset Characteristics and Bankruptcy Costs

20. Asset Characteristics and Bankruptcy Costs
• Financial distress can be particularly damaging to
firms that produce research and development-
intensive goods and services, for two reasons.
• First, most of the production expenses are sunk costs,
which can be recovered only with a long period of
profitable sales.
• Second, “cutting-edge” goods require ongoing R&D
spending to ensure market acceptance.
20

21. Agency Costs and Capital Structure
• Jensen and Meckling (1976): agency cost theory of
financial structure
• Agency costs of outside equity
• Managers who own less than 100% of the firm have an
incentive to expropriate wealth from the firm’s
investors.
• Excessive perquisite consumption
• Less effort devoted to increasing firm’s value
21

22. Using Debt to Overcome the Agency
Costs of Outside Equity
• Using debt means a firm can sell less external
equity and still finance its operations.
• Using debt reduces managerial perquisite
consumption.
• External debt serves as a bonding mechanism.
• Debt subjects managers to direct monitoring by
public capital markets.
22

23. • Bondholders begin taking on an increasing fraction
of the firm’s risk as firms use more debt.
• Shareholders and managers still control the firm’s
investment and operating decisions, so managers
have incentives to transfer wealth from
bondholders to themselves and other
shareholders.
• For example, managers might sell bonds and then pay a
huge dividend to shareholders, leaving bondholders
with an empty corporate shell.
23
Agency Costs of Outside Debt

24. 24
Agency Costs of Outside Debt
Problems with
outside debt
Asset substitution (bait and switch)
Underinvestment
Bondholders protect themselves with positive and negative
covenants in lending contracts.
Agency costs of debt are burdensome, but so are solutions.

25. • Asset substitution is the promise to invest in a safe asset to obtain an
interest rate reflecting low risk, and then substituting a riskier asset
promising a higher expected return.
• Underinvestment occurs when a firm’s shareholders refuse to invest
in a positive-NPV project because most of the benefits would be
realized by bondholders.
25
Agency Costs of Outside Debt

26. 26
The Trade-off Model Revisited
VL = VU + PV(Tax shields) – PV(Bankruptcy costs) – PV(Agency costs)

27. • Profitable firms should borrow more than
unprofitable firms because they are more likely to
benefit from interest tax shields.
• Firms that own tangible, marketable assets should
borrow more than firms whose assets are
intangible or highly specialized.
• Safer firms should borrow more than riskier firms.
• Companies should have a target debt ratio.
27
Implications of the Trade-off Model

28. Empirical Observations on Leverage
• Some studies find that the most profitable firms in
an industry have the lowest debt ratios.
• Leverage-increasing events, such as stock
repurchases and debt-for-equity exchange offers,
almost always increase stock prices, while leverage-
decreasing events reduce stock prices.
• Firms issue debt securities frequently, but
seasoned equity issues (equity issues from firms
that already have stock) are rare.
28

29. Assumptions Underlying the Pecking-
Order Theory
• Dividend policy is “sticky.”
• Firms prefer internal financing (retained earnings
and depreciation) to external financing of any sort,
debt or equity.
• If a firm must obtain external financing, it will issue
the safest security first.
• As a firm requires more external financing, it will
work down the “pecking order” of securities:
1. Safe debt
2. Risky debt
3. Convertible securities
4. Preferred stock
5. Common stock (as a last resort)
29

30. Assumptions Underlying the
Pecking-Order Theory
30
Assumptions
Manager acts in best interests of
existing shareholders.
Information asymmetry between managers
and investors.
Two key predictions about managerial behavior
Firms hold financial slack so they don’t have to
issue securities.
Firms follow pecking order when issuing
securities: sell low-risk debt first, equity only as
last resort.

31. Limitations of the Pecking-Order Theory
• It implies that firms have no target capital structure
and that the debt ratios observed in the real world
ought to fluctuate randomly.
• The theory also seems at odds with evidence that
firms owning more tangible assets typically use
more leverage.
31

32. How Signaling with Capital Structure
Can Convey Information
• A firm’s managers can adopt a heavily leveraged
capital structure, committing the firm to pay out
large sums to bondholders.
• In equilibrium, firms signal good news by issuing
debt.
• Investors know that with good prospects can afford
to take on debt, they recognize a debt issuance as
good news, and they bid up the firm’s shares.
32

33. Empirical Evidence on Signaling Models
• Intuitively appealing model, but relatively little empirical support
• Leverage ratios are, if anything, negatively related to profitability in
almost every industry.
• Signaling models predict a positive relationship.
• Asset-rich companies use far more debt than do growth companies
with intangible assets.
• Information asymmetry is more severe for growth companies, which thus
should have a greater need to signal.
33

34. • Baker and Wurgler (2002) argue that firms time the market by issuing
equity when share prices are high and issuing debt when they are
low.
• As a consequence, a firm’s capital structure simply reflects the
cumulative effects of its managers’ past market-timing activities.
• Relatively new theory; still being tested
34
The Market-Timing Model

35. 35
Finding The Optimal Capital Structure For a Specific
Company
• As more debt is added and the probability of losses increases, the
marginal benefit of debt curve slopes downward.
• Graham (2000) shows how to estimate the present value of tax
shields for any firm by running simulations that allow the firm’s
earnings to fluctuate over time.

36. Franco Modigliani (1918-2003) and Merton Miller (1923 -2000) (Nobel
Prize winners in 1985 and 1990 respectively)

37. Underpinning assumptions
• That the financial markets are perfectly competitive
• no individual has power over the price
• zero transaction costs, taxes or other constraints on the free operation of the markets.
• zero barriers to entry and exit to the market.
• Individuals and firms can borrow or lend any amount at a risk free rate of interest free of
transaction charges and costs.
• That buyers and sellers are economically rational and fully informed in their search for
personal value.
• There are no regulatory restrictions on short sales.
• Information is freely available to all actual and potential market traders.
• There is no bankruptcy risk.

38. The value of the firm formula
• is the expected value of the income stream to the firm,
• E is the market value of its equity,
• D is the market value of its debt,
• V is the total market value of equity plus debt and r'e is the
cost of equity capital in a pure equity firm.
( )
e
X X
r
D E V

 

X

39. M&M propositions
"the average cost of capital to any firm is completely independent of its
capital structure and is equal to the capitalisation rate of the pure equity
stream of its class".
The expected return on a share (re) is equal to the rate of return which would
be generated by a pure equity company of the same risk class (r'e) with the
addition of a financial risk premium equal to the debt to equity ratio times
the difference between the pure equity return and the market rate of
interest (rd).
the cut-off point for investment in the firm will in all cases be the pure rate of
return on equity and will be completely unaffected by the type of security
used to finance the investment".

40. Static trade off theory
Cost of capital
Gearing
WACC (no default/no tax)
Tax effect dominates Default risk dominates
AAA BBB B C
WACC (including tax
and default risk)
Credit rating

41. (1 )
F i d d F d d
WACC R ERP w Tw R Tw w
  
     
Risk free
rate of return
The equity premium
adjusted for financial risk
The tax saving on the risk
free and the default
component of the cost of debt
The default
premium
Ungear and regear the beta
and adjust the gearing ratio
Adjust for a change
in the default premium
and the gearing
Do not
change
Adjust for a change
in the default premium
and the gearing
What each
component
means
What each
component
means
What needs to
be corrrected
What needs to
be corrrected

42. Dividend Policy
• Does it matter whether the firm finances new investment internally
through retentions or externally through the capital market?
• Does it matter to investors whether they get their money now in the
form of a dividend or later through capital appreciation?
• To what extent can managers exploit their power to give or withhold
dividends to their own advantage?

43. The capital cycle of the firm
Operating cash flow
Operating cash flow
Internal Generated Capital
(Equity)
Capital investment
Capital investment
Corporation Tax
Corporation Tax
Interest payments
Interest payments
Free cash flow to equity
Free cash flow to equity
Debt
market
Equity
Market
Dividends Retentions
Income
tax

44. M&M’s dividend irrelevance hypothesis
• If a firm has positive net present value projects (when discounted
at its weighted average cost of capital) then it should invest in
those projects.
• The means by which a firm finances those investment projects is
strictly irrelevant:
• if the company has insufficient internally generated funds then
it can raise the capital on the external market.
• if it so chooses, it can pay its cash surpluses as dividends and
refinance itself through the capital market to meet its
investment needs.
• The firm’s investors are indifferent to whether the firm distributes
or not providing what is retained is invested at a rate equal to or
more than their required rate of return. If they require personal
liquidity they can create ‘home made dividends’.

45. Comparative analysis of firms facing
different investment conditions
NPV<0
IRR<WACC
NPV=0
IRR=WACC
NPV>0
IRR>WACC
Investment will reduce the value
of the firm
Investment will leave the value
of the firm unchanged
Investment will increase the
value of the firm
Cash rich firm: weak investment
opportunities with many products
in their mature phase.
Cash generative but surpluses in
balance with return paid to
investors through dividends or
other means
Cash poor firm: high investment
programmes consuming cash at a
faster rate than its generation
through ongoing activities.
Company should return surplus
cash to investors either as
dividends or via share repurchase
Company should seek to resolve
the investment as either value
adding or destroying and then act
accordingly
Firm should accept all positive
net present value investments
either through retained earnings
or new capital issue or both
Firm whose core business is
contracting either through market
or managerial failure
This state arises in highly
competitive markets where
NPV’s are driven down to zero
with little opportunity for product
differentiation. Inefficient firms
will move towards failure.
Firm is expanding its business
opportunities and investing
heavily in both real and
intangible assets

46. Problems with the dividend irrelevance
hypothesis
• Transaction costs
• The impact of taxes
• Information asymmetries
• The problem of uncertainty and the ‘bird in the hand argument’
• The clientele effects

47. Dividend Policy
• A constant or growing money payout related to the nominal value of the
share.
• A constant payout ratio may be used by firms who wish to maintain a stable
link between their earnings, their rate or reinvestment and the dividend they
payout each year.
• A zero dividend policy is a common option taken by firms during their growth
phase as all available surpluses are reinvested within the business.
• A residual dividend policy is one where a dividend is only paid if there are no
further current investment opportunities that can be exploited..

48. Estimating Dividend Capacity
Operating cash flow
plus returns from joint
ventures activities
Less tax
Less interest payments
Operating cash flow
plus returns from joint
ventures activities
Less tax
Less interest payments
Free cash flow to equity
(before capital expenditure)
Free cash flow to equity
(before capital expenditure)
Capital expenditure
plus acquisitions by
takeover/merger
Less disposals Less
new capital issues
Capital expenditure
plus acquisitions by
takeover/merger
Less disposals Less
new capital issues
Free cash flow
to equity net of
reinvestment
Free cash flow
to equity net of
reinvestment
Potential dividend payable

49. Post session activity
• Critically reflect on the capital structure of a listed company (apart
from the company in the assignment)
• Apply academic theories/concepts in analysing publicly available on
the firm.

50. Share repurchase
Three ways in which a company can repurchase its shares:
• A fixed price tender offer where the company offers a
fixed price to all its current shareholders in order to
induce them into selling whole or part of their holding.
• Open tender offer where the company invites its
shareholders to make a ‘bid’ (usually within a range of
prices) for a price at which they are prepared to part
with their shares.
• Open market repurchase where the company either
directly or through an intermediary buys back their
shares on the market.

51. Share Repurchase v. dividends
• A firm may wish to alter its capital structure in favour of higher gearing
without issuing new debt capital.
• Where a company has run out of new value adding investment opportunities
it may find it to its advantage to cut back the size of the firm.
• Where dividends are taxed differently to capital gains.
• Repurchases are invariably seen as a positive sign by the markets and a signal
that management believe that the company is undervalued in the market.
Empirical evidence lends some support to this hypothesis in that the reaction
of prices to increasing dividends tends to be more favourable than the
announcement of a repurchase.