Chapter 12 - Capital Structure PDF

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Chapter 12 - Capital Structure Lecture and Textbook Notes...

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Chapter 12 - Capital Structure 12.1 Measures of Leverage ●

A lever is a machine that applies a force exerted at one end to produce a larger force at th either end

Risk

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Business Risk - Standard deviation of EBIT Financial risk is only created by debt - taking on debt means you pay interest - Standard deviation of Earnings Per Share

Operating Leverage ●

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Operating Leverage - Fixed costs create operating leverage. Fixed costs accentuate the variability of operating profits relative to the variability of sales. Measured by the degree of operating leverage Earnings before interest and taxes - Earnings before interest and taxes are deducted High operating leverage occurs in companies with a large amount of fixed assets because those companies typically have very low variable costs Degree of Operating Leverage (DOL) - The percentage change in EBIT divided by the percentage change in sales

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■ When D = 0, Change in EBIT = Change in EPS ○ How much a change in sales would change EBIT ○ High DOL = high business risk = high decline in EBIT due to a change in sales Uses the top part of the income statement

Financial Leverage ●

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Financial Leverage - Debt creates financial leverage. Financial leverage increases the expected return on equity, but it also accentuates the variability of net income relative to the variability of operating profit. Measured by the degree of financial leverage (DFL) With a high degree of financial leverage, a small increase in operating profit produces a very big change in shareholder profitability Degree of Financial Leverage (DFL) - The percentage change in EPS divided by the percentage change in EBIT

○ ○ Change in EPS due to a change in EBIT Uses the bottom part of the income statement where interest and stuff come into play

Total Leverage ● ●

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Total Leverage - A measure of leverage that combines operating and financial leverage Degree of Total Leverage (DTL) - The percentage change in EPS divided by the percentage change in sales

○ ○ An increase in one of them, increases the total leverage Firms with high operating leverage often have low financial leverage Average debt ratio for all firms is 26% Firms within an industry tend to have similar capital structures Uses the entire income statement

How much debt should a firm have? - Tools to assess optimal debt levels - Indifference analysis - find the point where they are indifferent between capital structures - Coverage ratios - ratio to compare against to see how we are doing compared to teh market - Lender standards - standards to compare against to see how we are doing compared to teh market - Cash flow analysis - analyse how much cash you have bc taking on debt requires cash Debt -

Reduces taxes owed Increases risk of bankruptcy and volatility of EPS Disciplines managers b/c they have less cash and have to be more care - reduces managerial flexibility

12.2 The Effects of Leverage EPS and ROE as EBIT Changes ●

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ROE and EPS increase as EBIT increases ○ With debt: the ROE and EPS fluctuate more. Bad is word, but good is better ○ When operating profit is lower, no debt is better. When operating profit is higher, debt is better Example: An unlevered ( = no debt) firm in 3 different economic situations

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Example: A levered ( = debt) firm in 3 different economic situations

EBIT-EBS (Indifference) Analysis ●

The indifference point at which the EPS of both capital structures is the same

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○ More than $100 of EBIT, levered company is better ○ Less than $100 of EBIT, unlevered company is better Intersection is the EBIT-EPS indifference point ○ Useful for selecting between alternative financing options ○ ■ ■ ■ ■

Interestdebt = interest due under the debt option Interestequity = interest due under the equity option ndebt = number of shares outstanding under the debt option nequity = number of shares outstanding under the equity option

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Indifference Point -

○ Advantages and Disadvantages of using Financial Leverage ○ Leverage creates the risk of bankruptcy. With leverage and weak sales (i.e., below an EBIT of $50 where the light green line cuts the x-axis), you may not be able to pay your interest expense (so EPS is negative) and you could be forced out of business by creditors. This cannot happen if the firm is all-equity financed because there are no creditors to satisfy - the all equity line never enters the negative EPS range ○ Leverage increases shareholder profits (when times are good). With leverage

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and strong sales, the debt-financed capital structure produces an EPS of $7 but the all equity only generates $4. In effect, by using debt, the firm is able to earn money for shareholders by using someone else’s money (lenders) Leverage increases risk. This is reflected by the steeper slope of the light green line. With leverage, there is a higher variance of profit (EPS or ROE), which explains why firms are considered to be more risky when they’re leveraged

The EBIT-EPS line is steeper for the leveraged capital structure, so EPS will be higher for EBIT values above the indifference point. Shareholders prefer a higher EPS

12.3 Capital Structure with No Taxes ● ●

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Each model builds on the previous one and so each model is more realistic than the last First Model ○ Impact of leverage on value assuming perfect capital markets ○ No taxes, no cost of financial distress, no transaction costs, and no information asymmetries ○ No Optimal Capital Structure - The capital structure that produces the highest firm value of all capital structure Second Model ○ Include tax benefit of debt ○ Optimal capital structure is 100% debt Third Model ○ Includes transaction costs ○ Financial Distress - The events leading up to and including bankruptcy, such as the violation of loan covenants ○ Principal-Agent Problems - The problems and costs that occur when an agent does not maximize the utility of the principal ○ Static Trade-Off Theory - The theory that the optimal capital structure is determined by a trade-off of the value of tax shields against financial distress costs and the agency costs and benefits

M&M Proposition 1: Debt and Value (no taxes) ● ● ●

In a perfect capital market (means no taxes, among other things) The value of the firm is only based on the value of its assets The value of the firm doesn’t change with its capital structure

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○ ○ Value of the company is just based on the cash flows Value of the company is the PV of it’s FCF

Value of unlevered company

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Market Value before Share Repurchase ■ If FCF if constant forever

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(with taxes)

= or EBIT/kWACC (no taxes) Ku = required return by shareholders

Value of a levered company

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VL = EBIT - kdD ■ Bondholders (debt) get kdD

= Equity + Debt

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kD - the interest tax shields have the same risk as the bond coupons

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Examples: https://docs.google.com/spreadsheets/d/1ZQmLX4P8X_1mbMJ0nuJRsOn CQu7PhCKXEQG74ILeM8s/edit#gid=0 M&M Proposition 2: Debt and Required Returns ●

The WACC does not change as capital structure changes. It is determined by the riskiness of the company’s business assets ○ WACC is unaffected by leverage

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KU (aka required return on assets) = KWACC

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(no taxes) * (1-T) (with taxes) The return on equity is an increasing function of leverage because leverage makes equity riskier and shareholders compensate by requiring a higher return ○ The rate of increase is equal to the spread between kU and kD

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The WACC declines as leverage increases

○ Conclusions ○ Firm value is determined by the left-hand of the balance sheet, the firm’s assets, and the cash flow generated by them. A firm cannot change its market value by splitting its cash flows into different streams. The market value of any firm is independent of its capital structure ○ The shareholder’s required return (kE) rises with leverage

Examples: https://docs.google.com/spreadsheets/d/1ZQmLX4P8X_1mbMJ0nuJRsOn CQu7PhCKXEQG74ILeM8s/edit#gid=0

12.4 Capital Structure with Taxes Interest Tax Shield ●

Since interest is tax deductible, taxes are lower for companies that are debt financed (leveraged)

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M&M Proposition 1: Debt and Value with Taxes M&M Proposition 2: Debt and Required Returns with Taxes ● ● ● ● ●

WACC is constant as leverage increases with no corporate taxes If the firm is all equity financed, then the cost of equity is the WACC Conclusions ○ With or without taxes, M&M showed how leverage increases the risk of equity and the required return of shareholders. With no taxes, M&M showed that capital structure is irrelevant—there is no one capital structure that maximizes the value of the company. With the addition of taxes, M&M showed that the optimal capital structure is 100% debt. But this implication isn’t realistic. The average ratio of debt to value is around 27% ○ M&M made a number of assumptions to arrive at their conclusions. If we don’t like the conclusions, then we have to relax the assumptions. To derive a theory that predicts an optimal capital structure of less than 100% debt, we relax the

assumption of no transaction costs. In particular, in the next section, we assume that financial distress is costly and that contracts between corporate stakeholders are not perfect

12.5 The Static Trade-off Theory Financial Distress Costs ●

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When a company cannot make interest or principal payments to its creditors, it declares bankruptcy ○ Can reorganize and become profitable again ○ Can cease operations and go out of business Secured creditors are paid first, unsecured creditors have the next claim ○ Debenture - Unsecured bonds ○ Shareholders have a residual claim and usually receive nothing Bankruptcy Costs ○ Direct - cost of filing, paying attorneys ○ Indirect - arise because a firm facing financial distress must work to recover its economics health ■ Loss of customers and key employees Financial Distress Costs - The direct and indirect costs of bankruptcy that are incurred prior to and in bankruptcy

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Under the static trade-off, the value of the leveraged firm is equal to the sum of the unlevered firm and the value of tax shields ■

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With taxes, the optimal capital structure is 100% debt

Agency Costs ● ●

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Separation of ownership and control in modern corporations creates the potential for misalignment of objectives Costs of principal-agent problems ○ Contracting costs associated with efforts to make sure that agents act in the best interest of the principal ○ Waste associated with bad decisions made by managers pursuing their own selfinterest ○ Increased leverage can increase firm value if it reduces agency costs Agency costs arise between owners and lenders ○ Covenants - Covenants are conditions that the issuer must meet. Covenants include such things as maximum debt-to-equity ratios, minimum working capital levels, restrictions on dividend policy and capital expenditures, reporting requirements, and any other conditions the lender feels will increase the probability of timely repayment. If the borrower fails to keep any of the covenants, then the lender has the right to declare the borrower in default and to demand immediate repayment

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Conclusions about Optimal Capital Structure ●

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Risk and Return ○ As we saw in the section on EBIT–EPS analysis, debt increases the expected return to shareholders but it also increases the variability of those returns. Debt also introduces the risk of bankruptcy. Tax Considerations ○ As discovered during our exploration of M&M Propositions 1 and 2, debt creates an interest tax shield, which leaves more free cash flow for investors and raises the value of the firm. This implies that firms should use some debt in their capital structure. Rising Debt Means Rising Costs of Financial Distress ○ As debt increases, so do financial distress costs. The optimal debt level balances this cost against the tax benefit of using debt. Debt Affects Principal - Agent Conflicts

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As debt increases, managers have less free cash flow that they can waste, but shareholders are increasingly likely to accept long-shot projects. Debt has agency benefits and costs. Each company’s exposure to these costs is different, and so the balance of benefits and costs is different. Differences in Risk among Firms ○ Different firms are subject to different levels of risk. Firms with variable sales and/or high operating leverage have a higher probability of financial distress and are likely to maintain low debt ratios to keep total risk reasonable. Other Considerations ○ Some firms value the flexibility provided by low debt more than other firms do. ○ Some owners and managers are more concerned about risk than others. ○ Some owners want to retain control of their companies and so prefer debt over equity (since new equity will dilute their ownership). ○ Finally, not all companies need the interest tax shield and so use less debt. Graham and Tucker (2006) study a sample of 44 companies that use tax shelters to reduce their corporate taxes. Those companies have debt ratios that are about 8% lower than comparable companies.

Chapter 12 Formulas:

EPS of Levered Firm Dividend Cash Flow -

Value Find Equity 1. Find Vu 2. Find Vl 3. Calculate E = V - D Cost of Equity -

D/V from E/V WACC -

Ke -

Holding Period Return Which of the following is not an indirect cost of financial distress? - legal fees

The static tradeoff theory argues that the optimal capital structure is a tradeoff between a benefit and a cost. What is the primary benefit? - the tax shields from debt...