Capital structure theory


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Capital structure theory

  1. 1. Financial Leverage and Capital Structure Policy
  2. 2. Capital Structure Theories <ul><li>Modigliani and Miller model </li></ul><ul><li>Trade-off theory </li></ul><ul><li>Agency theory </li></ul><ul><li>Signaling theory </li></ul>
  3. 3. Capital Structure Effects on Value <ul><li>The impact of capital structure on value depends upon the effect of debt on: </li></ul><ul><ul><li>WACC </li></ul></ul><ul><ul><li>Feedback to FCF </li></ul></ul>
  4. 4. MM entered a theoretical universe where the following conditions existed <ul><li>No taxes </li></ul><ul><li>Capital structure has no impact on operating cash flows </li></ul><ul><li>No agency costs </li></ul><ul><li>No financial distress costs, riskless debt </li></ul><ul><li>No information asymmetry </li></ul><ul><li>Perpetual cash flows, no growth </li></ul><ul><li>Individuals and corporations borrow at the same rate </li></ul><ul><li>No transactions costs </li></ul>
  5. 5. MM Proposition 1 with Zero Taxes <ul><li>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 </li></ul><ul><li>V U = value of unlevered firm (no debt) V L = value of levered firm (has debt) and </li></ul><ul><li>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 </li></ul>
  6. 6. MM Proposition 2 with Zero Taxes <ul><li>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. </li></ul>
  7. 7. WACC depends on Business Risk <ul><li>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’. </li></ul><ul><ul><li>Business risk = Variability in EBIT </li></ul></ul><ul><ul><ul><li>Industry cyclicality </li></ul></ul></ul><ul><ul><ul><li>Fixed costs (operating leverage) </li></ul></ul></ul>
  8. 8. Investors Indifferent <ul><li>Investors desiring a specific level of leverage can create it by borrowing in their own portfolio </li></ul><ul><li>MM Conclusion: Capital structure can be viewed as irrelevant under very restrictive assumptions. </li></ul>
  9. 9. 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
  10. 10. MM Proposition 2: No taxes Cost of Capital (%) Debt/Value Ratio (%) r s WACC r d r sU
  11. 11. MM Proposition 1 with Taxes <ul><li>The value of an unlevered firm is equal to EBIT (1-T) capitalized at the cost of equity </li></ul><ul><li>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 </li></ul>
  12. 12. MM Proposition 2 with Taxes <ul><li>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 . </li></ul>
  13. 13. 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)
  14. 14. Cost of Capital (%) Debt/Value Ratio (%) MM Proposition II: With taxes r s WACC r d (1 - T) r sU
  15. 15. Value of Firm, V (%) Debt V L V U MM relationship between value and debt with taxes TD V U
  16. 16. Trade-off Theory <ul><li>MM theory ignores financial distress costs , which increase as more leverage is used: </li></ul><ul><ul><li>Higher debt costs, including negotiation and monitoring by creditors (MM assume constant cost) </li></ul></ul><ul><ul><li>Feedback to Free Cash Flow </li></ul></ul><ul><ul><ul><li>Rejection of high risk but +NPV investments (under-investment) </li></ul></ul></ul><ul><ul><ul><li>Lost customers, suppliers, and employees </li></ul></ul></ul><ul><ul><ul><li>Loan covenants, which constrain growth </li></ul></ul></ul><ul><ul><ul><li>Investment in Capital (NOA) increases as lose trade credit </li></ul></ul></ul><ul><ul><ul><li>‘ Fire sales’ of assets to raise cash </li></ul></ul></ul><ul><li>Contradicts assumption of MM that capital structure doesn’t effect operating cash flows </li></ul>
  17. 17. Trade-off Theory (cont.) <ul><li>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. </li></ul><ul><li>Since these costs are only significant at high levels of debt, WACC could be relatively unaffected for many capital structures </li></ul>
  18. 20. Trade-off theory suggests these types of firms will use more debt <ul><li>Strong cash flow </li></ul><ul><li>Low variability in cash flow </li></ul><ul><li>Low growth opportunities (predictable funds needs and less risk of jeopardizing growth investments) </li></ul><ul><li>Large size (safety and lower growth) </li></ul><ul><li>Marketable collateral (less service or R&D intensive) </li></ul><ul><li>Product not subject to ongoing maintenance/warranties, observable quality </li></ul><ul><li>Profitable enough to benefit from tax shelter </li></ul>
  19. 21. Debt can reduce Equity Agency Costs <ul><li>Equity agency problem is that managers might: </li></ul><ul><ul><li>use corporate funds for non-value maximizing purposes (perks, acquisitions, value-destroying growth) </li></ul></ul><ul><ul><li>or seek low risk due to undiversified interest in firm </li></ul></ul><ul><li>Problem is most significant in large firms with diffuse stockholders where management ownership is low </li></ul>
  20. 22. Debt can reduce Equity Agency Costs (cont.) <ul><li>The use of financial leverage: </li></ul><ul><ul><li>Bonds free cash flow for firms generating more cash than required to fund +NPV opportunities, reducing perk consumption and value-destroying growth. </li></ul></ul><ul><ul><li>Increases free cash flow by forcing efficiencies: failure risk gets managers’ attention </li></ul></ul><ul><ul><li>Substitute for other strategies: outside board members, stock ownership, large outside blockholders, takeover threat </li></ul></ul>
  21. 23. Debt can reduce Equity Agency Costs (cont.) <ul><li>Debtholders can serve as monitors for diffuse free-riding stockholders </li></ul><ul><li>However, debt agency costs will increase : negotiation, monitoring, covenants, under-investment </li></ul>
  22. 24. Signaling Theory <ul><li>MM assumed that investors and managers have the same information. </li></ul><ul><li>Where significant information asymmetries exist, stockholders assume: </li></ul><ul><ul><li>Company issues new stock when it is overvalued </li></ul></ul><ul><ul><li>Bonds are issued when stock is undervalued </li></ul></ul><ul><ul><li>Stock issues indicate lower expected FCF, unwilling to commit to increased debt service </li></ul></ul><ul><li>Leverage-decreasing events signal overvalued stock, and vice versa, supported by empirical data </li></ul>
  23. 25. Signaling theory results in Pecking Order Hypothesis <ul><li>Firms will choose the following sequence of funding sources to maintain financial flexibility and avoid negative signals </li></ul><ul><li>Retained earnings </li></ul><ul><li>Excess cash </li></ul><ul><li>Debt issuance </li></ul><ul><li>Stock issuance </li></ul><ul><li>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. </li></ul>Maintain borrowing capacity
  24. 26. Summing the theories <ul><li>This leaves us with: </li></ul><ul><li>V L = V U + tax benefit – financial distress </li></ul><ul><li>+ equity agency – debt agency + signaling </li></ul>Capital structure decision requires judgment!
  25. 27. <ul><li>Effect on sustainable growth: willingness to increase debt allows for higher growth rate now. </li></ul><ul><li>Debt ratios of other firms in the industry. </li></ul><ul><li>Lender and rating agency attitudes (impact on bond ratings). </li></ul>Other factors in setting the target capital structure