Capital structure & Financial planning
Week 2 - Capital structure policy
Capital structure is the relative proportion of securities (debt, equity and others) that a firm has
outstanding. It’s the right side of the balance sheet, and typically we measure capital structure as
the debt-to-value ratio: D / (D + E).
Higher level of debt to equity means a firm is more levered. Unlevered firms have zero debt. Firms
like utilities tend to have higher debt than technology firms: Those with easy to liquidise assets
can have debt since they have something to sell in the case of financial distress. For firms whose
primary assets are intellectual property, this is harder.
Key question: Does a firm’s capital structure affect its firm value?
Perfect markets
In a perfect market, securities are fairly priced, there are no frictions: No taxes, no transaction
costs.
Modigliani and Miller proposition 1: Total firm value is independent of capital structure in perfect
capital markets. The Law of One Price means the combined values of debt and equity must be
equal the NPV of the cash flows of a firm, which don’t change because of capital structure.
VL = VU = A = D + E So the levered firm value equals the unlevered firm value which equals the
value of the assets, which equals (market value) debt + equity.
Numerical example: If we have a $800 investment returning in one year $1400 or $900
depending on the economy (50/50 odds), then the expected cash flow is $1150. Assume risk free
rate rf = 5% and the risk premium is 10%, meaning the cost of capital is 15%. This makes the
NPV 1150/1.15 = 1000 - 800 = $200.
Option 1-Finance it with equity: Your profit is the amount equity investors are willing to pay for the
project right now minus the actual needed investment. Thus when they’re willing to pay $1000,
you immediately profit $200. Firm value is what investors paid for it, the equity value: $1000.
The shareholders either get a 40% or -10% return, making the expected return of unlevered
equity 15%.
Option 2-Finance it leveraged. Suppose you borrow $500 first, how much can you then get
investors to pay in equity: The cash flow guarantees debt repayment, but the investors see their
returns decrease to $875 and $375 respectively once you subtract the $500 plus 5% interest. The
expected average equity value that remains is $625. Discounting the value of equity of a levered
firm is not done by the same discount rate as that of an unlevered firm: Risks have increased. If
we used the 15%, firm value would have increased because of financing. MM1 told us this is
impossible in perfect markets.
We know the Law of One Price means the value of the equity must still be $500. Thus a 25%
return on equity is apparently what investors demand for the levered firm: Higher returns are
demanded for the more risky equity, keeping firm value fixed.
Homemade leverage states that investors are indifferent between leveraged and unleveraged
firms in perfect capital markets, meaning VL = VU. Investors can replicate any level of leverage they
desire: Undoing firm leverage is done by creating a portfolio that holds enough risk-free bonds to
offset the increase in risk and return of a leverage increase of the firm, making the return equal
that of the unlevered firm. Borrowing on your own and then investing in equity is a way of
increasing leverage yourself. Investors are unwilling to pay more for anything they can achieve
themselves: That’s why homemade leverage means (de)leveraging doesn’t increase firm value.
Formally: Modigliani-Miller I: In perfect capital markets, total firm value equals the market value of
the free cash flows generated by its assets and is unaffected by its choice of capital structure.
VL = VU = A = D + E.
,The cost of capital of levered equity equals the cost of capital of unlevered equity plus a risk
premium proportional to the debt equity ratio: rE = rU + D/E(rU - rD). Thus leveraging a firm adds a
risk premium, the difference between rU and rD, proportional to the D/E level.
Imperfect markets
No we add imperfections, starting
with:
-Taxes. As seen on the right, a
leveraged firm pays to two investors:
Its net income goes to equity
investors, and its interest expense to
debt holders. Only net income is
subject to corporate tax: Interest
paid to debt holders is not, meaning
the total payout of a leveraged firm to all investors is higher by the amount we save in corporate
tax: Interest tax shield = Corporate tax rate * Interest payments. Thus in this case it’s 35% of $430
that we’re able to increase our payout to investors with because of the imperfection of taxes.
Tax shields increase cash flows to investors, causing an annual gain increasing the value of the
firm by the present value of all future tax shields: VL = VU + PV (interest tax shield).
The PV of the tax shield equals corporate tax rate * (interest rate * debt) discounted by the interest
rate, since this is the appropriate discount rate for firm value as well. As both interest rates drop
out, PV of interest tax shields = TCD, the corporate tax rate times the firm debt. VL = VU + TCD.
The tax advantage of debt decreases WACC:
Why not 100% leverage a firm then? In a world where
taxes are the only imperfection, we wouldn’t expect
firms to pay an average of 30% of EBIT in interest, but 100%, this is caused by:
-Distress costs. Imperfection two due to suppliers and customers becoming hesitant for the fear
of bankruptcy. Distress costs are the costs arising from bankruptcy, due to trouble meeting its
debt obligations, which increases in change as the level of debt increases.
Two types of distress costs:
-Direct costs of bankruptcy due to creditors awaiting payment and lawyers, but more importantly:
-Indirect costs of distress: In anticipation fo bankruptcy, firms lose 10 to 20% of their value, lose
customers, creditors, employees, and suppliers, and must engage in fire sales of assets at a large
discount.
So higher debt increases payout to investors but
also the probability of bankruptcy and financial
distress, causing the Tradeoff theory: Balancing tax
benefits and distress costs.
VL = VU + TCD - PV(financial distress costs).
Displaying both a firm with high and low distress
costs, we see the value of a levered firm is
maximised where the tradeoff is perfect, as for a
level of debt too high the distress costs more than
offset the interest tax shield benefits.
This explains the large industry differences in
leveraging (D/(D+E) levels). This is determined by:
-The magnitude of distress costs, which is
decreased by the tangibility of assets as firms with
easier to liquidate asses incur less distress costs (they can simply sell hotel buildings for example,
while pharma companies must intellectual property).
-The probability of distress, depending on cash flow volatility: Firms with more stable cash flows
(utilities) can have much higher debt levels as they’re more certain of their income, while e.g. tech
firms have a higher Beta.
, -Agency costs, is the third imperfection. Agency costs arise when there are conflicts of interest
between stakeholders. One example is managers making decisions that benefit themselves at
investors’ expense: Reduce effort, spend excessively on CEO perks, or engage in unprofitable
‘empire building’ where they just increase their holdings.
Apart from benefiting themselves, managers may also cause agency costs by benefiting
shareholders (equity holders) at debt holders’ expense.
Debt changes managerial incentives:
-Debt may reduce agency costs as ownership remains more concentrated, making monitoring
easier, and funds at management’s discretion decreases, which reduces waste.
-Debt may increase agency costs, ax excessive risk taking when the risk of distress is high will
harm debt holders while benefitting equity holders.
Excessive risk taking: Since debt holders have the first claim to a firm, and they do not get more
than the value of their debt, they don’t profit from volatility of returns. Investing in a project that
has a probability of giving very large returns but also such a probability of being unprofitable that
it reduces expected firm value will benefit the equity holders who otherwise expect to earn 0, but
debt holders see their certain level of income disappear. This is a way debt may increase agency
costs as it encourages excessive risk taking.
Another is under-investment. The firm on
the right is in financial distress as its debt
is 1000 but its value 900. It could
increase this value by investing in a new
(risk free) project requiring 100 of
investment and returning 150, increasing
NPV. However, this investment has to be
made by equity holders, who would see
their value of equity increase only after all debt holders have their debt seen paid, thus debt
holders reap the benefits from a value increase that equity holders must finance if the firm is
valued below its debt, causing the investors to be unwilling to pay for it, causing under-
investment. This way, high debt may increase agency costs.
Implications for firm value: VL = VU
+ PV interest tax shield (TC*D)
- PV financial distress costs
+ PV Agency benefits (less wasteful spending)
- PV Agency costs (excessive risk & under investment)
Trade off theory with agency costs is what follows, as
shown on the right.
A fourth imperfection is information asymmetry as
managers’ info about the firm and its future cash flows is
superior to that of outside investors. Investors rely on
information from the managers but expect their statements
to be biased, and therefore focus on their actions.
Managers can signal about the firm’s financial health:
-Signalling theory of debt: Issuing debt signals the firm is
able to meet regular payments, indicating stability.
-Signalling equity sends a negative signal: Managers would only issue new shares when they
think they’re overvalued (or at least properly valued), but would never issue new shares when they
believe the firm is undervalued. Investors know this, and discount an equity issue: The share price
reacts negatively to equity issuing.
This leads to the Pecking order theory: For financing new projects, managers prefer:
1. Internal financing (retained earnings)
2. External financing: Issuing debt.
3. External financing: Issuing new equity.
