16 TOPIC CAPITAL STRUCTURE PART 1
Reading: Chapter 15 Practice Questions: see the word document on the website Objectives:
Understand what Financing Policy entails Know how to use the M&M Theorem to focus financing issues Be able to debunk the WACC fallacy Understand the difference between financial distress and economic distress Understand the basics of bankruptcy Understand the tradeoff between the tax benefit of debt and expected costs financial distress Understand the debt-overhang problem and its implications for debt policy
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FINANCING POLICY (CAPITAL STRUCTURE):
Up until now we have focused on the investment decisions of a financial manager. We will now concern ourselves with the Financing Decisions. That is, where do we get the cash to make the necessary investment? These questions are usually asked in the context of capital structure. Should the firm use equity or debt to finance its projects. This is determined by the fundamental question of how much total debt the firm should issue. Recent research confirms that firms have long-term target debt/equity ratios and they choose their financing so as to move them toward their target So if a firm is below its debt/equity ratio, its more likely to finance a project or acquisition with debt
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The Modigliani and Miller Theorem is where we start.
M&M THEOREM
1. Assume: a) b) c) d) No Taxes No Transactions/Information Costs Fixed Operations* Fixed Real Investment Policy**
2. Then The market value of the firm (i.e. the sum of all claims against it, including debt) is independent of the choice of financing policy (i.e., there is no unique capital structure that maximizes firm value.) Fixed Operations means the firm operates the same way regardless of how it is financed; i.e. how its financed doesnt change managements incentives to cut costs, managegments ability to steal or waste money, relationships with customers or suppliers, etc. Fixed Investment Policy means that the firm will always make the same investments regardless of how it is financed.
** *
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Proof Can be done with a no-arbitrage argument (Modigliani and Miller, American Economic Review, 1958) A discounted cashflow argument is more intuitve: With an all-equity firm, the value is:
VA =
E[Ct ] t t =1 (1+ ra )
E[Ct ] E[Pt ] (1+ ra )t (1+ rd )t t =1
Now if we add debt, the value of equity is:
VE =
Where Pt are debt service payments. The value of debt is:
E[ P ] t VD = t t =11+ r
d
VD + VE = VA
QED Theres also the Pizza Pie proof: Investment policy and operations fix the size of the pie. No taxes or transactions cost means none of the pizza is lost in slicing. The value of the firm is unaffected by how the potential cash flows generated by the firm are carved up. The market sees through the form of the claims on the firms cash flow to the substance of the firm.
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THE IMPORTANCE OF THE M&M THEOREM
How can they seriously argue that financing policy doesn't matter? Are they nuts? All of the assumptions are unrealistic. If M&M were true we would see random D/E ratios across firms (theyre not) CFOs wouldnt worry about financing (but they do) The important contribution is that now we have four places to look for how Financing Policy is going to matter If financing policy does affect firm value, it must be because a) b) c) d) Taxes matter Information or Transactions costs matter Financing policy impacts operations Financing policy impacts investment decisions
M&M show that any argument about the benefit of Debt or Equity unrelated to the above is fallacious.
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THE WACC FALLACY
Prior to M&M, some people made this argument: Increasing debt will reduce a firms weighted average cost of capital because debt holders require a lower return than do equity holders, even ignoring the effect of taxes. Why is this wrong?
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Disproving the Fallacy Using Math: WACC is a weighted average of the cost of equity and debt. In a world without taxes, its just equal to:
rassets =
Where:
E D requity + rdebt V V
requity = cost of equity (or required expected return on equity) rdebt = expected return on debt (same thing as cost of debt) E = value of equity D = value of debt V = E+D (value of firm) Lets solve the above equation for the cost of equity:
requity =
rassetsV Drdebt D = rassets + (rassets rdebt ) E E
Modigliani-Miller theorem tells us that the value of the firm, V, and rassets, dont change with Debt Thus the above equation shows that the cost of equity capital, requity, must go up as debt, D, goes up relative to equity, E. Hence you cant decrease rassets by increasing the size of debt relative to equity (also called leverage)
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The Economics of WACC So the math tells us that the cost of equity goes up with leverage enough to keep the cost of capital the same What is the economic reason? Equity becomes riskier Also, as leverage increases, debt becomes riskier, increasing the cost of debt Both these effects ensure that increasing debt cannot reduce your WACC, apart from the tax effect Whats wrong with the following rationale for using lots of debt? Our fund uses as much debt as possible when it takes equity stakes because that way we maximize our expected SOUND returns.
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ONE REASON FOR CAPITAL STRUCTURE TO MATTER: TAXES
Lets look at taxes Consider the firm as having 3 claims on it Equity holders Debt holders Uncle Sam wants a big slice of pizza
Corp Tax
Equity
Debt
Any action which reduces the governments claim against the firm must increase the value of the firm Important Fact: Interest paid on debt is tax deductible at the corporate level, but dividends paid to equity are not Issuing debt allows the firm to reduce its taxable income and therefore, its tax payments. Firm value increases by the present value of all future tax-shielded income.
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SO WHY ARENT FIRMS 100%DEBT FINANCED?
More debt means greater probability of financial distress Financial distress can destroy value How? Bankruptcy costs 1) Lawyers & Court fees a. Small percent of firm value 1-3%, so negligible 2) Bankruptcy can disrupt a firms operations
Even when a firm is not in distress, even the possibility of distress can cause problems 1) The debt overhang problem 2) Shareholder-creditor conflicts 3) Excessive shareholder risk taking
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FINANCIAL DISTRESS AND BANKUPTCY
Financial distress means not have enough cash to service debt 1) Not the same thing as economic distress! 2) If a firm uses only equity financing, it will never enter financial distress no matter how bad business gets 3) A firm that finances its projects with a lot of debt can enter financial distress even if its business is doing okay What happens in financial distress? Three basic possibilities 1) Workout: all creditors agree to swap some debt for equity Often doesnt work. 2) Chapter 11 Bankruptcy reorganization a. Firm continues operating stops paying creditors 1) Often need Debtor In Possession (DIP) financing to keep operating b. Judge must approve all major expenditures of the firm 1) Essential suppliers usually continue to get paid 2) Customer warranties usually honored c. Firm & creditors come up with a reorganization plan 1) Shareholders wiped out or severely diluted 2) Creditors get stock in exchange for writing down debt 3) Majority of creditors and judge must approve plan 4) Creditors get paid in order of priority: DIP, Secured debt, senior unsecured debt, subordinated debt 5) The creditors can liquidate the firm instead if they can get more from shuttering the business and selling the assets 3) Chapter 7: liquidation
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BANKRUPTCY COSTS
1)Lawyers & Court fees: small percent of firm value 1-3%, so negligible 2) Disruption a firms operations a. Customers reluctant to trust warranties or product guarantees b. Need to get all expenditures approved by judge creates problems i. Delays in supplier payments disrupts supply chain 1. Suppliers may demand cash in advance 2. Some important suppliers may go bankrupt ii. May not be able to invest in positive NPV projects iii. Harder to extend credit to customers iv. Financial institution bankrtupcies can disrupt markets 1. Payment clearing services disrupted 2. Customers cant draw lines of credit 3. Trade execution delayed and disrupted 3) Costs of Chapter 7 (liquidiation) a. May not be able to obtain full market value of assets (fire sales) b. Firm may be worth more as a going concern, but debt holders may liquidate it anyway. Why?
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BANKRUPTCY COSTS VS. BANKRUPTCY RISK
Bankruptcy costs refer to aspects of the bankruptcy process that reduce the value of the firm as a whole Back to the pie analogy: bankruptcy occurs because the pie has shrunk due to worse-than-expected business conditions In bankrtupcy, slices of the pie are reallocated among creditors Bankruptcy costs are like the portion of pizza lost due to re-slicing
Whats wrong with this statement? If the firm goes bankrupt, equity holders get wiped out. High levels of debt make this more likely to happen, so it is in the best interests of equity holders that the firm not take on too much debt.
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DEBT OVERHANG (MYERS, 1977)
Even if the firm is not yet bankrupt, a strong possibility of financial distress may prevent it from taking on good investments. A simple stylized example: Frim has Assets in Place that next year will generate $100 with probability 0.5 and $20 with probability 0.5. The has borrowed in the past, and has to repay $50 in debt next year. Notice, the firm may still be able to meet its financial obligations; it is not bankrupt What are the current market values of Debt & Equity, assuming no further investment? For simplicity, assume a discount rate of zero. Now suppose there is a new project with an NPV of $5 that requires an investment of $10. For simplicity, assume the riskeless rate is 0 and the project is riskless, so it pays off $15 next year no matter what. Will it be possible for the firm to issue equity to finance the project?
I leave it as an excersice to the student to show that the same result holds even if you add risk and discounting to the project.
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IMPLICATIONS FOR CAPITAL STRUCTURE
What kinds of firms do you think are more likely to encounter a debt overhang problem if they take on a lot of debt?
What do a firms future investment options tell you about its optimal capital structure?
Why would you expect a utility to have more debt than a tech company?
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