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Unformatted text preview: TBS 907 Spring 2005 MODULE 3 Lecture 3 CAPITAL STRUCTURE AND FINANCING STRATEGIES Explain the different types of long term financing instruments and list their sources, advantages and disadvantages Understand the concept of business risk and financial risk and explain the effects of financial leverage. Explain the concept of capital structure and understand the `Capital Structure Irrelevance Theory' of Modigliani and Miller Explain the roles of taxes and other factors that may influenced capital structure decisions. CHAPTER OBJECTIVES CHAPTER OBJECTIVES (CONTD) Understand the concept of optimal capital structure based on a tradeoff between the benefits and costs of using debt. Explain the Pecking Order Theory, TradeOff Theory and the Free Cash Flow Theory of Capital Structure Explain how financing can be viewed as a marketing problem. Outline the main factors that financial managers should consider when determining a company's financing strategy. Sources of Long Term Financing When a firm decides to acquire longterm assets it must also decide how to finance them. The firm can raise these funds internally or externally. Internal funds are primarily in the form of cash flow from operations plus the liquidation of marketable securities There is a limit to the availability of internal funds. Therefore the firm must either abandon profitable projects or turn to external sources of longterm funds in the "CAPITAL MARKETS" There are many methods for the firm to raise its required funds. The most basic and important instruments are stocks and bonds or equity and debt. Equity Financing Equity Capital refers to the money that any business associates inject directly into the business. In a proprietorship or partnership it is in the form of an owner's contribution and appears on the balance sheet as owner's equity. In an incorporated business anyone contributing equity capital receives shares in the business, thus equity capital results in some degree of ownership to those shareholders. Equity Financing ( contd) Equity can be raised through several methods: Initial Public Offering Rights Issues New Issues Equity Financing ( contd) Characteristics of Equity
Ownership interest in the company Limited Liability No Short Term Payments Larger Funding Amount OpenEnded "Exit date" i.e. shareholders can sell their ownership at any time. Less Restrictions High Expected Return Equity Financing ( contd) Advantages of Equity The concept of limited liability increases the prospects of large amount of funds being raised through an equity issue. The firm is not required to pay dividends. Thus, in the event of a cash flow squeeze, the firm can skip the payment of dividends without suffering any legal consequences. Also, because equity has no maturity date, the firm has no obligation to redeem it. Because the firm's equity provides a cushion against losses by creditors, the sale of equity lowers the cost of issuing additional debt. Equity Financing ( contd) Disadvantages of Equity The issue of equity usually brings new owners to the firm diluting the control of the existing owners. Managerowners who are unwilling to share control of their firms will often try to avoid equity financing for this reason. Dividends are paid out of aftertax earnings whereas interest payments are tax deductible. This affects the relative costs the firm of debt and equity financing.. The cost of issuing equity is usually higher than the cost of raising the same amount of money by selling additional debt. Debt Financing Debt is an obligation to pay a specific amount of money to another party. It involves the lender advancing a sum of money `Principal' to the borrower for a specified period. In return the borrower pays the lender an agreed rate of interest at specified intervals and at the end of the agreed period repays the outstanding `Principal'. Debt Financing ( contd) Types of Debt Financing LongTerm Loans Leasing Syndicated Loans Mortgages Debentures Corporate Bonds Debt Financing ( contd) Characteristics of Debt Takes on a creditor Periodic Payment Smaller funding amounts Maturity Date Lower expected returns Many restrictions Short Term vs. Long Term Debt Fixed vs. floating interest rates Secured vs. Unsecured Debt Domestic vs. Foreign Debt Debt Financing ( contd) Advantages of Debt Interest payments are tax deductible, whereas as equity and preferred share dividends are paid out of aftertax earnings Debt holders do not share in the value created by growth opportunities; their payments are limited to interest and principal Bondholders do not vote, enabling owners to maintain greater control over the firm If the value of the firm drops precipitously, the equity shareholders will have the option of defaulting on their debts and turning over the firm to the debt holders Issue costs on bonds are generally lower than those on equity. Debt provides protection against unexpectedly high inflation because its real cost varies with the rate of inflation. Cost of Debt capital is generally less than that of equity capital. Debt Financing ( contd) Disadvantages of Debt Greater use of debt financing increases the firm's financial risk; possibly leading to bankruptcy and eventual liquidation. According to CAPM, the increase in financial leverage raises the firm's cost of equity capital. Bonds typically contain restrictive covenants that limit the firm's financial and operating flexibility. These restrictions may reduce the firm's ability to engage in value maximizing behaviour. The real cost of debt will be greater than expected if the rate of inflation turns out to be unexpectedly low. Other Sources of Long Term Financing Besides debt and equity there are other sources of longterm financing Preference Shares Convertible Preference Shares Convertible Bonds or Debentures Capital Structure Capital structure The mix of debt and equity finance used by a company. The capital structure which maximizes the value of a company. Does the value of the net operating cash flow stream depend on how it is divided between payments to lenders and shareholders? Optimal capital structure Business Risk vs. Financial Risk All firms are subject to business risk, for example, new competitors may emerge, technology may change, new government regulations may be introduced or consumer preferences may change. These and other factors contribute to a firm's's business risk which will be reflected in changes in the firm's net operating cash flows. When a firm only uses equity, then variations in the return are attributable only to the business risk However, when a firm uses debt finance as well as equity, the shareholders are exposed to higher risk. This results from the fact that payments to lenders are fixed. These payment must be made even if the firm suffers a serious decline in its operating cash flows. Therefore, the risk faced by the shareholders is directly related to the proportion of debt in the company's capital structure. The risk borne by the shareholders as a result of financial leverage ( i.e. use of debt) is known as financial risk Business Risk vs. Financial Risk TOTAL RISK = BUSINESS RISK + FINANCIAL RISK FINANCIAL LEVERAGE Then why add debt? By Borrowing the firm can increase the expected return to shareholders. This is known as Financial Leverage. This is providing that the rate of return on the firm's assets is greater than the interest on its debt, borrowing will increase or `gear up' the rate of return to shareholders. Leverage is measured by Ratio of Debt to Equity Ratio of Debt to Total Assets Interest Coverage Ratio Determinants of Capital Structure Introduction to the different theories of Capital Structure Miller and Modigliani Analysis Trade Off Theory Pecking Order Theory Miller and Modigliani Analysis Assumptions Capital markets are perfect. Companies and individuals can borrow at the same interest rate. There are no taxes. There are no costs associated with the liquidation of a company. Companies have a fixed investment policy so that investment decisions are not affected by financing decisions Miller and Modigliani Analysis Proposition 1: The value of a firm is independent of its Capital Structure: the law of conservation of value. Proposition 2 (Without Taxes) :The cost of capital would increase with the introduction of cheaper debt capital by an amount exactly equal to the value of the cheaper debt capital Proposition 2 ( With Taxes): The Value of the levered firm will increase by the present value of the tax shield on debt thus there is an incentive for the firm to increase the sources of debt. Proposition 3: The discount rate used by the firm for investments is independent of the methods used to finance the investment. The discount rate used should reflect the riskiness of the cash inflows received from the investment Miller and Modigliani Analysis (contd) Proposition 1:The value of a firm is independent of its Capital Structure: the law of conservation of value VL= VU The earning power of the assets is the key issue NOT the method of financing the assets which ultimately affects the distribution of the cash inflows from the assets. Perfect substitutes cannot exist in the same market at different prices. If firm value was a consequence of the capital structure then the arbitrage process would be exploited to take advantage of different values. Miller and Modigliani Analysis (contd) Example
Two firms identical in every respect except for their capital structure have net operating earnings of $80,000. Firm XYZ has $200,000 debt outstanding at an interest rate of 10%. The cost of equity capital is 15% for XYZ while for ABC an unlevered firm the cost of equity is 14%. Assume a perfect market, how an arbitrage process could take advantage of the difference in market values Miller and Modigliani Analysis (contd)
Net Operating Income $80,000 Interest Payment Earnings Available to S/H $60,000 Cost of Equity Capital (k) Market Value of Equity (E) Market Value of Debt (D) Market Value of the Firm (V= E + D)
* ABC $80,000 n/a $80,000 14% $571,430* n/a $571,430 XYZ $20,000 15% $400,000* $200,000 $600,000 M. V of Equity = NOI/ke Miller and Modigliani Analysis (contd)
Assume an investor owns 5% of XYZ the investor can adopt the following riskless process to increase wealth. 1. Sell shares in XYZ for $20,000 2. Replicate the leverage of XYZ and borrow $10,000. 3. Invest $30,000 in ABC @ 14% ($30,000 X 14%) = $ 4,200 4. Repay interest on $10,000 loan @10% = $1,000 5. Net gain = $4,200 $1,000 = $3,200 6. Investment in XYZ = .015 x 20,000 = $3,000 7. Net gain from Arbitrage = $3,200 $3,000 = $200 Effectively, it doesn't matter where you get the money to buy an asset, it is the earning power of the asset that is the determination of wealth and not the distribution of the assets returns to equity or debt providers. Miller and Modigliani Analysis (contd) Proposition 2 (Without Taxes) :The cost of capital would increase with the introduction of cheaper debt capital by an amount exactly equal to the value of the cheaper debt capital In a perfect market context with no taxes, risk free debt and Investors are able to borrow at the corporate rate then the value of any firm will be the residual cash flow (net operating income NOI) divided by the cost of capital represented by: V = NOI or k = NOI K V Miller and Modigliani Analysis (contd)
The cost of equity in an all equity firm will increase with the introduction of debt due to the introduction of financial risk, in the case of MM proposition 2 the cost of equity will increase according to the following formula: ke = k*e + (k*e kd) D ...................(1) E Formula 1 specifies that as a firm increases it's sources from debt the advantages of this cheaper debt will be offset by equity holders increasing their required returns to offset the increased financial risk. Miller and Modigliani Analysis (contd)
The determination of the cost of capital for a firm with debt in it's capital structure is by the general formula: WACC= ke E + kd D Where WACC = Weighted Average Cost of Capital V V The MM proposition effectively states that as D/V increases at the expense of E/V then the advantage will be offset by an increased cost of ke thus negating the advantage of the cheaper kd. The MM Proposition 2 is based upon the notion of the "natural conservation of risk" this specifies that the "total risk" of a firm remains unchanged when the firm changes its capital structure if the debt is risk free. In effect, the shareholders are carrying the total risk and the risk free cash flows that are transferred to the debt providers will increase the uncertainty of the cash flow to the equity holders, thus equity holders will respond to the increase in uncertainty by increasing their required rates. When debt is not risk free, the debt providers will increase their rates with increased use of debt and a point is reached where the cost of equity starts to decline, this is due to the debt providers "assuming the business risk of the firm". Miller and Modigliani Analysis (contd)
The following diagrams show the cost of capital for the risk free debt and the risky debt: The Proposition 1 capital structure diagram shows that the cost of capital stays constant throughout all degrees of leverage.
Cost of capital Cost of equity WACC Cost of debt D/E Miller and Modigliani Analysis (contd)
Extending the argument to include "risky debt", the above diagram changes thus
Cost of equity WACC Cost of debt D/E risk free debt risky debt Miller and Modigliani Analysis (contd) Proposition 2 ( With Taxes): The Value of the levered firm will increase by the present value of the tax shield on debt thus there is an incentive for the firm to increase the sources of debt. MM Analysis with Taxes With the introduction of Corporate Taxes and the tax deductibility of interest payments on debt the value of the levered firm will increase by the present value of the tax shield on debt thus there is an incentive for the firm to increase the sources of debt. The logical conclusion would thus be to have firms with 100% debt. This state is of course bankruptcy, a position all managers strive to avoid!!! Miller and Modigliani Analysis (contd)
VL= VU + PV (tax shield on debt) So VL = VU + t cI where I = Interest payments kd tc = Corporate tax kd = Cost of debt But : I = D kd Thus: VL= VU + t c D So the value of the levered firm will exceed the value of the unlevered firm by the tax shield provided for interest payments. Miller and Modigliani Analysis (contd) Proposition 3 The discount rate used by the firm for investments is independent of the methods used to finance the investment. The discount rate used should reflect the riskiness of the cash inflows received from the investment FINANCIAL DISTRESS Financial distress occurs when promises to creditors are broken or honoured with difficulty. Sometimes Financial distress leads to bankruptcy. Investors are aware that levered firms can fall into financial distress and they therefore reflected this in the market value: Value of the firm = VU + PV of the Tax Shields PV of the costs of financial distress. COSTS OF FINANCIAL DISTRESS Costs of financial distress cover several specific items. Bankruptcy costs : These occur when the shareholders exercise their right to default. Thus the shareholders hand over the company to the creditors when the decline in the value of the assets triggers a default. The direct costs of bankruptcy are the legal and administrative costs. The indirect costs of bankruptcy are harder to measure such as: Reluctance to do business with a firm that may not be around for long. Potential employees are unwilling to sign on. Suppliers are disinclined to putting effort into servicing the firm's account and demand cash. Not every firm that faces financial distress goes into bankruptcy. The firm Risk Shifting Refusing to Contribute Equity Capital Cash In and Run Playing for Time Bait and Switch may be able to get out of its liquidity crisis and avert bankruptcy. There is however conflict among the equity holders and the debt holders in terms of the methods of recovery: TRADEOFF THEORY OF CAPITAL STRUCTURE The firm's debtequity decision is a tradeoff between interest tax shields and cost of financial distress. It recognizes that target debtratios vary from firm to firm. Firm's with safe, tangible assets and plenty of taxable income to shield out to have high target ratios e.g. airlines Unprofitable companies with risky, intangible assets ought to rely primarily on equity e.g. hightech growth firms Firms with too much debt should issue stock, constrain dividends or sell off assets to raise cash to rebalance the capital structure Companies with well established markets for their products but low growth rates cash cows ( BCG ) should normally have high debt equity ratios. However, there are contradictions: It does not explain how most successful companies thrive with little debt. THE PECKING ORDER THEORY Starts with asymmetric information; manager know more about the company than the outside investors This asymmetric information affects the choice between internal and external financing and between new issues of debt and equity securities. This leads to a pecking order , in which: 1. Firms prefer internal finance. 2. They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends. 3. Sticky dividend policies, plus unpredictable fluctuations in profitability and investment opportunities, mean that internally generated cash flow is sometimes more than the capital expenditure and other times less. If it is more the firm pays off debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities. 4. If external finance is required, firms issue the safest security first. That is, they start with debt , and then possible hybrid securities such as convertible bonds, then perhaps equity as a last resort. CAPITAL MANAGEMENT & CORPORATE STRATEGY Capital management involves optimizing the source of funds to maximize firm value. Should the firm's assets be financed by: Equity Debt Hybrids Convertible bonds Converting preference shares Reset preference shares? What is the optimal mix of funds the optimal capital structure? The optimal capital structure depends on financial considerations
advantage to debt. Interest payments are tax deductible, so there is a tax But don't borrow too much, because financial distress might become an issue: Reconstruction costs Investment opportunity costs Lost sales Financial distress costs are an important consideration. Opler and Titman (1994) Choose firms in economically distressed industries (negative sales growth, stock price declines). Firms that are highly levered two years before the distress period are most severely affected by distress. Three reasons are proposed: Customer driven customers refuse to buy from highly levered firms during periods of distress. Competitor driven strong competitors launch price wars to gain market share. Manager driven weak firms are first to have to downsize. Optimal capital structure also depends on strategic considerations. Use capital structure to signal good prospects to the market: Issuing equity signals that your stock price is overvalued and/or you can't get debt. Use capital structure to keep managers in line: Large free cash flows are tempting (perks, empire building, so issue debt to soak this up. Use capital structure to beat up on competitors: A wellcapitalized competitor can initiate and sustain on price war against a highly levered competitor. .....lots of strategic considerations. Use capital structure to negotiate with unions and suppliers: More debt means less free cash flow and less room for increasing wages and input costs. Use capital structure to capture market share: More debt signals to competitors that you need to sell more aggressively. What might happen if we change the capital structure? How will changing the capital structure of a firm affect key financial statistics such as: The cost of capital; The value of the entity; The credit rating of the entity; The ability of the entity to generate a predictable dividend stream for shareholders. Should the firm have more leverage? Advantages: Potential decrease in cost of capital and increase in value on entity. Decreases shareholder stakes, capital for use elsewhere. Leaves less free cash flow at the discretion of management imposes discipline. Should the firm have more leverage?.....cont'd Disadvantages: Potential increase in probability of financial distress. Potential loss of operating and investment flexibility. The basic framework for answering these questions. Choose a target capital structure. Specify the distribution of "value drivers" Generate a time series of value drivers one scenario. Reconstruct a full set of financial statements and compute a range of relevant financial statistics. Repeat many times Monte Carlo generation of more scenarios. Repeat with a different capital structure. SUMMARY OF CAPITAL STRUCTURE What determines Capital Structure Gearing Risk Factors determining the Amount of Debt Timing Return Control Flexibility Shareholder Value SUMMARY OF CAPITAL STRUCTURE Sources of Finance Corporate Life Cycle Startup Growth Maturity Declining Equity Debt CASE STUDY The Novel Co. Ltd., which is effectively controlled by the Novel family although they now only own a minority of the shares, is to undertake a substantial new project which required external finance of $4m million, a 40% increase in gross assets. The project is to develop and market a new product and is fairly risky. About 70% of the funds required will be spent on land and buildings. The resale value of the land and buildings is expected to remain about, or above, the initial purchase price. Expenditure during the development period of 47 years will be financed from Novel's other revenues, with a consequent strain on the firm's overall liquidity. If, after the development stage, the project proves unsuccessful the project will be terminated and the assets sold. If, as likely, the development is successful the project's assets will be utilized in production and Novel's profits will rise considerably. However, if the project proves to be extremely successful then additional finance may be required to expand production facilities further. At present Novel is all equity financed. The Financial Director is uncertain whether he should seek funds from a financial institution in the form of an equity interest, a loan (long or short term) or convertible debentures. Case study continued.... Required: Describe the major factors to be considered by Novel in deciding on the method of financing the proposed expansion project. Briefly discuss the suitability of equity, loans, and convertible debentures for the purposes of financing the project from the point of view of: Novel The provider of finance a) b) Clearly state and justify the type of finance recommended for Novel. ...
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This note was uploaded on 07/10/2009 for the course FIN FIN taught by Professor Dr. during the Spring '09 term at Baptist College of Health Sciences.
- Spring '09