Capital Structure Decisions: Part 1
I. The traditional approach to firm valuation and leverage
A. Assumes that there is an optimal capital structure
Use of leverage can (Lough):
1. Lower the firm's cost of capital
2. Raise firm's total value
From Business Finance: A Practical Study of Financial Management in Private Business Concerns, by William H. Lough, New York, The Ronald Press Company, 1919, pp. 105-106.
Advantages of Borrowing
"The habit of borrowing," says Hartley Withers, "is a modern invention." There was formerly a custom among all, well-ordered governments and business enterprises, of amassing treasure for use in emergencies; without hoarded treasure even the largest owner of property would have been helpless. Today the wisest financial policy is to pile up not treasure, but credit. To be sure, sound credit may require the possession of a certain proportion of gold and securities; but this treasure no longer exists for its own sake so much as for a support and guarantee to credit.
More and more as credit facilities increase and credit machinery works more smoothly, business enterprises are financed with borrowed capital. The great advantages of borrowing are its cheapness and its ease. It is cheaper to borrow than to secure a co-owner or a group of co-owners for a business, because of the greater security that is offered to the lender. To put the same thought in terms of corporate financing, first-class bonds may be sold on a 4, 5, or 6% basis, whereas preferred shares sell on a 6, 7, or 8%, basis, and common shares on a still higher basis. Hence, the larger the proportion of capital which the individual or corporation can borrow, the larger is the yield on the owned capital.
Take a very simple illustration. Suppose a corporation with $100,000 capital is regularly earning 10%, or $10,000 a year; let us say that $20,000 of the capital is borrowed at 5% making the interest payment $1,000. Then the $80,000 of owned capital will have left an income of $9,000, or a little over 11%. Let us now make the assumption that the business is of such a character that $80,000 can be borrowed at 5%, making the annual interest payment $4,000. In that case the $20,000 of owned capital will have left an income of $6,000, or 30%.
We have here an explanation of the profit-making possibilities-when properly financed-of enterprises which yield only a small average return on the invested capital. Most public utilitv companies, for instance, secure only a moderate yield on their actual investment, but these companies hold properties which can be mortgaged up to a high percentage of their value. Hence, at least one-half the capital is borrowed and the owned capital may obtain very good dividends. According to the Electrical Railway, Review, the issued stock of all the electrical railways in the United States for 1912, had a par value Of $2,945,000,000, and for 1913, $2,808,000,000, a decrease Of $137,000,000. The bonded indebtedness of these companies for 1912 was $2,641,000,000, and for 1913, $2,814,000,000. We see here not only a large proportion of borrowed capital, but its rapid increase from year to year, with a corresponding decrease in owned capital. The same thing is true of real estate operations. An extreme case is that of a New York corporation known as the "Forty-two Broadway Company," which has a capital stock of $6oo and a bonded indebtedness of nearly $5,000,000.
B. Weighted average cost of capital approach (Ch 10 E&F)
C. As debt increases, the firm's equity holders will require a higher rate of return. However, up to some point the cheaper cost of debt outweighs the higher return paid to shareholders (Make overhead p.430 E&F)
II. The Modigliani and Miller position (MM)
1. Capital markets are perfect
a. Information is both costless and readily available
b. No transactions costs
c. All securities are infinitely divisible
d. Investors are rational
e. Investors have homogeneous expectations about probability distributions of returns
f. No corporate taxes
g. No growth all cash flows are perpetuities
h. Both individuals and corporations borrow at the risk-free rate.
B. Proposition 1: Value is independent of capital struc-ture.
A. Proposition 2: The cost of equity to a levered firm is equal to the cost of equity to an unlevered firm in the same risk class, ksU, plus a risk premium whose size depends on both the differential between the costs of equity and debt to an unlevered firm and the amount of leverage used:
B. Sum of the parts must equal the whole
C. Investors can replicate any capital structure by substituting personal leverage for corporate le-verage
D. Two firms alike in every way except capital struc-ture must have the same total value. If this is not true, arbitrage opportunities are possible.
1. Example: Consider two firms identical in every respect except firm A is all equity financed and firm B has $30,000 of 12% bonds outstanding
The traditional approach suggests that B may have a higher total value and a lower average cost of capital than A
Look at the two firms' income statements:
Firm A Firm B
Net Operating Income $10,000 $10,000
Interest on Debt 3,600
Earnings Available to
Common Shareholders $10,000 6,400
Required Return on Equity 15% 16%
Market Value of Stock $66,667 $40,000
Market Value of Debt 30,000
Total Value of Firm $66,667 $70,000
Implied overall cost of capital:
rA = 15%
rB = 16%(40/70) + 12%(30/70) = 14.3%
MM argue that this situation cannot last because of arbitrage opportunities
Suppose you own 1% of firm B's stock valued at $426.66 by the market. Your expected return is 15% or in dollar terms $64.00 (400.00*0.16)
You could realize the same return by:
1. Selling the stock in Company B for $400.00
2. Borrowing $300 at 12%
Note: This is personal debt equal to 1% of the debt of company B, your previous proportional ownership of the company.
3. Buy 1% of the shares of Company A the unleve-red firm for $666.67
Your expected return on the investment in Company A is 15% or $100 (666.67*0.15)
Deduct interest charges from this:
$100 Return on Investment in A's stock
- 36 Interest Charges (300*0.12)
$64 Net Return
This is the same dollar return as your investment in company B but your cash outlay is:
$666.67 Cost of 1% of A's stock
-300.00 Obtained from personal borrow-ing
$366.67 Net Cash Outlay
This is less than the $400 cash outlay in firm B's stock. Therefore, investors would prefer investing in firm B by means of personal leverage.
1. Homemade leverage
2. What happens to the rates of return on equity?
a. The price of A's shares increases leading to a decrease in rAE
b. The price of B's shares decreases leading to an increase in rBE
c. The arbitrage process continues until there is no further opportunity for reducing one's investment outlay and achieving the same dollar return.
d. At equilibrium the value of the to firms must be the same. This implies that the cost of capital for the two firms must be the same.
B. Personal Taxes (Miller 1977)
1. No optimal capital structure for individual firms
2. There is an optimal aggregate level of debt for the corporate sector as a whole
3. Argued that the presence of personal taxes might reduce or eliminate the tax advantage of interest deductibility at the corporate level.
II. Relaxing the perfect capital market assumptions
A. Corporate Taxes
1. If interest payments to debtholders are treated differently than dividend payments to sharehold-ers, firm value will be affected by the choice of debt/equity mix.
2. Interest payments for corporate debt are tax de-ductible
a. Additional debt lowers taxes
b. Leads to reduction in firm's overall costs
3. Value of Levered Firm with corporate taxes:
VL = VU + D
Where: = the firm's tax rate
D = the amount of debt the firm will have out-standing perpetually.
D is the present value of the tax shields
4. Present Value of the tax shields:
Where: r = yield on debt rD = interest payment each period
rD = after-tax savings if the debt level is maintained at D forever
Suggests firms should try to maximize the amount of debt in their capital structure.
1. Why don't firms use 99.99% debt in their capital structure?
a. In a world of certainty (about CFs) this would work. With certainty a firm knows how much debt it can support so there is no risk of bankruptcy.
b. In a world of uncertainty about cash flows
(1) Taxes and the probability of bankruptcy
(a) Without certain cash flows (Vari-able CFS)
(b) The probability of financial dis-tress increases as the firm's debt level increases (ceteris paribus)
(c) As the firm adds debt to its capi-tal structure:
i) Investors impound both the value of the extra tax shields and the higher probability of bankruptcy into the value they are willing to pay for the firms shares
(d) When: Marginal Cost of Finan-cial Distress equals the Marginal Benefits of the Added Tax Shields, Firm Value is maximized. (See overhead)
(2) This is called the static-tradeoff theo-ry
(3) Static-tradeoff theory is appealing but:
(a) Doesn't explain why some firms choose to use almost no debt when their earnings levels and variabil-ity of earnings suggest they can safely support more debt
(b) It doesn't explain why managers prefer using retained earnings to fund expansion
(c) It doesn't explain why firms used debt before corporations were taxed.
II. Alternative Methods For Observed Capital Structure
A. "Pecking Order" Theory -Myers (1984), Donaldson (1961)
1. Managers usually have more and better information about the value of the firm's assets than outside investors. (Asymmetric Information) Riskier cash flows imply more asymmetric information.
2. Managers are assigned to maximize the value of (current) shareholders [not future] wealth
3. Thus, managers will want to issue more shares when outside investors think the firm is worth more than it really is and will be reluctant to issue shares if the stock is undervalued.
4. New investors will understand management's motives
a. If equity is issued, new investors will be suspicious about firm value and discount the price they are willing to pay.
b. If the discount is greater than the NPV of the project the funds are to finance, the manager will not issue the shares and forego an otherwise profitable project.
c. Therefore, managers finance with retained earnings or high grade debt in order to guard against foregoing profitable projects.
5. Pecking Order: Managers prefer to use securities in this order (in order of safety):
a. Retained Earnings (Internal Funds)
b. Debt (Safe or High Grade)
c. Hybrid securities
(1) Convertible Preferred Stock
(2) Convertible Debt
(3) Preferred Stock
d. Common Stock
6. Pecking Order Theory suggests firms may have less debt outstanding than it appears the firm's earn-ings can support.
7. The debt capacity assures the firm will always be able to raise safe funds and not forego positive NPV projects if equity is the only source of capi-tal.
8. Empirical Evidence
a. Firms with intangible assets or growth op-portunities borrow less than firms with tan-gible assets
b. Fits nicely into pecking order theory
(1) Intangible assets exhibit the greatest amount of uncertainty
(2) Given this uncertainty, issuing risky securities may result in a wealth tran-sfer from current shareholders
(3) Thus managers will not issue such claims
III. Other Reasons for Borrowing
1. Agency Costs
a. Managers are the delegated agents of share-holders
b. Therefore, manager's incentives may differ from shareholder's incentives
c. The agent may not exert the amount of effort (shirking) or make the same decisions as the principal if the principal were running the company. (Agency Costs)
d. Agency costs can be reduced through the use of leverage
(1) Leverage forces managers to distribute cash to securityholders
(2) With less cash:
(a) Temptation for perquisite consump-tion is reduced
(b) The risk of default gives managers less incentive to "goof off"
(c) The risk of default may cause man-agers to be replaced or more close-ly monitored
(d) If fired, future wages will proba-bly be reduced since the labor market for managers will not be willing to pay as much for a poor manager.
(e) Therefore, debt adds value to the firm
2. Signalling theory (Ross 1977)
a. Capital structure is used to signal a firm's quality to investors
b. High quality firms use more debt
c. Low quality firms are not able to support the debt level of high quality firms
d. If a low quality firm tries to falsely signal that it is a high quality firm, it runs the risk of bankruptcy which could lead to loss of jobs, salaries, bonuses, & perks for man-agement
IV. Empirical Evidence on Capital Structure
A. Exchange Offers (Masulis 1980 JFE)
1. When firms exchange debt for equity (increase leverage) firm value increases
2. When firms exchange preferred stock for equity firm value increases
3. Tax effects can't provide a complete explanation (Increase in value too great)
4. There also appears to be some wealth redistribu-tion from creditors to other securityholders as leverage increases
- More competitors are competing for the firm's cash flows
B. Conversion of convertible debt (a decrease in leverage)
1. Reduces firm value
2. Consistent with agency, signalling and tax theo-ries
C. Pecking Order and Asymmetric Information
1. Supporting evidence
a. Equity offerings _ 2-3% drop in stock price
b. Debt offerings _ no stock price reaction