3.2 Lecture_06_Thurs_30_July

3.2 - FINC 202 2009 Lecture 06 Optimum Capital Structure • • A Background to the Trade­off model How Firms move to a Target Capital Structure

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: FINC 202 2009 Lecture 06 Optimum Capital Structure • • A Background to the Trade­off model How Firms move to a Target Capital Structure 1 Cost of Capital % rs, rE WACC rd(1­tC) Value of Unlevered Firm = N x P0 Debt as % of capital Structure Share Price $ Share Price Share price if no distress costs But the value of a levered firm is the market value of its ________________ _______________________________ Debt as % of capital Structure 2 Miller and Modigliani: Capital Structure in a Miller perfect, simplified world perfect, Assumptions: Individuals can borrow at same rate as firms and governments at the risk­free rate No limit on how much can be borrowed No transactions costs Everyone has equal and universal access to all information Markets are efficient There are NO taxes Financial distress ___________________ 3 Miller and Modigliani: Assuming NO TAXES MM Proposition #1 The value of a levered firm is the same as the value of the unlevered firm VL = VU V = value of the firm L = levered U = unlevered (the firm is all­equity) Implication: Investors will be __________________________ 4 MM (NO TAXES): Proposition #2 The required rate of return on equity rises with increases in leverage The rise in rS relates to the increase in risk with increase in leverage Let rS be called r0 when there is zero leverage In following example, Addis Ltd let: • r0 = 15% • rd = rRF = 8% 5 MM NO TAXES: Proposition #2 Cont’d D rS = r0 + ( r0 − rd ) E where : rS = Required Return on Equity (Cost of Equity) r0 = Cost of Capital for All − Equity Firm rd = rRF = Cost of Debt D = Value of Debt E = ________________________________________ 6 MM (NO TAXES): Proposition #2 Cont’d r0 = 15% rd = 8% rS rS rS rS D = r0 + ( r0 − rd ) = ?? E 0 = 0.15 + ( 0.15 − 0.08) = 0.15 20, 000 10, 000 = 0.15 + ( 0.15 − 0.08) = 0.22 10, 000 12, 000 = 0.15 + ( 0.15 − 0.08) = 0.255 8, 000 No Debt 50% Debt 60% Debt 7 Problem 1: Sinbad Ltd With the No­taxes MM model, let Sinbad Ltd have r0 = 16% rd = 9% And the D/E ratio has three possible levels: • • • • Zero debt 20% debt and 80% equity 50% debt and 50% equity 80% debt and 20% equity Required: Find the four levels of cost of equity, rS 8 Solution 1 (1) 0 rS = 0.16 + ( 0.16 − 0.09 ) 10 = 2 rS = 0.16 + ( 0.16 − 0.09 ) 8 = rS = 0.16 + = 5 ( 0.16 − 0.09 ) 5 . (2) (3) (4) 8 rS = 0.16 + ( 0.16 − 0.09 ) 2 = 9 MM (NO TAXES): Proposition #2 Cont’d wd wS D E WACC = rd + rS = ?? D+E D+E No Debt 50% Debt 60% Debt 0 20, 000 0.08 + 0.15 = 0.15 20, 000 20, 000 10, 000 10, 000 0.08 + 0.22 = 0.15 20, 000 20, 000 12, 000 8, 000 0.08 + 0.255 = 0.15 20, 000 20, 000 10 Problem 2: Sinbad Ltd WACC • Given your answers to Problem 1 Show that the four levels D/E ratio in Problem 1 still produce just one level of WACC 11 (1) (2) (3) (4) ( 0% ) 0.09 + ( 100% ) 0.16 = ( 0.2 ) 0.09 + ( 0.8) 0.1775 ( 0.5) 0.09 + ( 0.5) 0.23 ( 0.8) 0.09 + ( 0.2 ) 0.44 Solution 2 = = = 12 Cost of capital % rS r0 WACC rd Debt-to-equity (D/E) 13 Now relax just one of the simplifying assumptions: Let there be company taxes 14 All-Equity Firm CFs Levered Firm CFs TAXES DEBT TAXES EQUITY EQUITY Levered firm pays less tax Sum of Debt + Equity CFs of levered firm is greater than the net equity CF in the all-equity firm 15 Miller and Modigliani: Value of the Levered Miller Firm [in an idealised world with company tax & without distress or bankruptcy] [in VL = VU + tC D Where the value of an unlevered firm (all­equity firm) is: MM formulation VU = N × P0 rS is r0 here D1 = N× ( r0 − g ) Formulation of the value of the all­ equity firm according to the discounted dividend model 16 Problem 3: Addis Ltd • • • 1. 2. 3. • Find the value of Addis Ltd at the following three levels if: The all­equity company has $20,000 capital Debt replaces equity via a share buyback The company tax rate is 40% Unlevered With 50% equity and 50% debt With 40% equity and 60% debt Note: You start with VU = $20,000 17 Solution 3 VL = VU + tC D 1. = $20, 000 + ( 0.4 ) ( $0 ) = 2. = $20, 000 + ( 0.4 ) ( $10, 000 ) = 3. = $20, 000 + ( 0.4 ) ( $12, 000 ) = 18 . After Tax cost of Debt The after­tax cost of debt is a decreasing function of the tax rate: • Ie, tC⇑ ⇔ rd(1­tC)⇓ rd tC rd(1-tC) …as % 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55 0.6 0.095 0.09 0.085 0.08 0.075 0.07 0.065 0.06 0.055 0.05 0.045 0.04 9.50% 9.00% 8.50% 8.00% 7.50% 7.00% 6.50% 6.00% 5.50% 5.00% 4.50% 4.00% It shows the rate of interest once the interest shield is taken 19 into consideration MM Proposition 2 (Company Taxes) The cost of equity increases with leverage; But this increase is dampened down by the company tax rate D rS = r0 + ( 1 − tC ) ( r0 − rd ) E Implication: Risk is still driving the rise in rS 20 Tasks 4 and 5 Use a 40% company tax rate to compute rS and WACC for Addis Ltd under the three capital structures: All­equity company ($20,000 equity) $10,000 debt / $10,000 equity $12,000 debt / $8,000 equity 1. 2. 3. 21 Solution to Task Four (calculation of rS) D rS = r0 + ( 1 − tC ) ( r0 − rd ) = E 1. 0 0.15 + ( 1 − 0.4 ) ( 0.15 − 0.08) 20, 000 = 10, 000 2. 0.15 + ( 1 − 0.4 ) ( 0.15 − 0.08) 10, 000 3. = 12, 000 0.15 + ( 1 − 0.4 ) ( 0.15 − 0.08) 8, 000 = 22 Solution 5 : (WACC Calculation) D E WACC = rd ( 1 − tC ) + rS = ?? D+E D+E 0 20, 000 0.15 ( 0.08) ( 1 − 0.4 ) + 20, 000 20, 000 = . 10, 000 10, 000 0.192 = ( 0.08) ( 1 − 0.4 ) + 20, 000 20, 000 12, 000 8, 000 0.213 = ( 0.08) ( 1 − 0.4 ) + 20, 000 20, 000 23 Cost of Capital % kS r0 kD D/E Ratio 24 Adjusted Present Value Model This is the value of the unlevered firm plus MM’s corporate tax leverage term plus an extra negative term: VL = VU + tC D − ( ProbBANKRUPTCY ) PVCOST OF BANKRUPTCY ( ) Note that tCD is the present value of the tax shield effect of debt (From MM) The PV of the cost of bankruptcy cannot be worked out easily. (Statistical analysis with Probit) Altman and Kishore (1998) provide a table of probabilities based on Bond Ratings • Bond ratings table is shown on the next slide 25 Bond Rating D C CC CCC BB B+ BB BBB AA A+ AA AAA Default Rate (%) 100.00 80.00 65.00 46.61 32.50 26.36 19.28 12.20 2.30 1.41 0.53 0.40 0.28 0.01 Probabilities calculated in 1998. Today’s probabilities would be a lot higher! 26 Measuring the Cost of Bankruptcy Direct Costs Cash outflows at the time of bankruptcy • • • This cost is ________________________ Legal fees Administration fees PV effects of delays in paying out the cash flows to claimants • Warner (1977) on 11 US railroad bankruptcies found that the time before release from bankruptcy court (chapter 11) was 13 years and the cost was 5.3% of TA at the time of bankruptcy 27 Measuring the Cost of Bankruptcy (2) Indirect Costs These are much larger • Loss of revenue via loss of customers When they perceive the firm is in trouble They stop for fear of paying for product or service that will not be delivered • Stricter terms from suppliers Purchases on a cash only basis! ⇒ working capital requirement ⇑ ⇒ ___________________________ 28 Measuring the Cost of Bankruptcy (2) More Indirect Costs of Bankruptcy Just about impossible to raise new cash for new projects • Neither debt nor equity investors want to put up funds ∀ ⇒ onerous capital rationing imposed on project selection ∀ ⇒ rejection of good investment projects Loss of managerial flexibility in decision making 29 Four types of firm with ESPECIALLY HIGH Four indirect bankruptcy costs: indirect Sellers of durables that require replacement parts over their life • 2. 1. Automobiles, lawn mowers, aircraft Sellers of products where it is difficult to tell the quality in advance • Firm’s reputation used to be a guarantor of quality. Example 30 __________________________________ 1. Sellers of products reliant on services and products produced by other firms • Apple Computer in 1997: software producers did not produce Apple Mac versions of software produced for Windows 2. Sellers of products requiring continuous support/servicing • _______________________________________ 31 Implications for Capital Structure (1) 1. Firms with volatile Cash Flows should use less debt than firms with less volatile Cash Flows • Utilities (in US) can have higher leverage than most firms because they often enjoy monopoly status and ________________________________ 32 Implications for Capital Structure (2) 1. If the government can be relied upon to bail a distressed firm out • • Firms will carry a higher level of debt, trusting in the safety net. Korean chaebol firms in the 1980s & 1990s • Family­controlled conglomerates 2. 1. Divisible (Coca­cola brand name is not !) Direct bankruptcy costs are higher if the firms assets are not easily: 2. ___________________ 33 How firms Choose Capital Structures Three alternative views: 1. • 2. Tradeoff is dependent on firm’s position in company lifecycle High­growth firms use less debt and more equity than do mature firms Tradeoff is dependent on managers’ perception of other firms’ capital structure in the same industry Tradeoff is dependent on biases of management 34 3. Getting to the Optimal Capital Structure Getting Implementing v NO change Fast v slow implementation Four Paths 1. 1. 1. 2. 35 Change v NO Change Let’s say we have identified an optimal capital structure different from the current one. This implies we are • either overlevered • Or underlevered But is the over/under­leverage meaningful? • Should we do something about it? Optimal structure maximises firm value • But there may be more complex considerations See next slide • Or should we just leave the structure unchanged? And risk reducing/destroying firm value? • ___________________________________________ 36 Change v NO Change: Currently Underlevered Firm Currently Firm has excess debt capacity But we (managers/shareholders) may: Value a high bond rating over _____________________________________ Require more flexibility than allowed by covenants imposed with extra debt Face very high bankruptcy costs if the firm is closely held and we err towards overleverage • Perhaps personal bankruptcy for shareholders (Closely held firms with few shareholders who have signed 37 personal guarantees.) • If we’re not certain about future financing needs, we need more (not less) flexibility • See next slide Change v NO Change: Currently Overlevered Firm Currently Big fear of bankruptcy • Strong incentive to shed debt But what if we are: • • • German firm? Japanese firm? Korean conglomerate (Chaebol)? 38 Immediate v Gradual Change Benefits of immediate change are: WACC⇓ and Firm Value⇑ ∀ ∆ Financing costs and EMH argument Disadvantages of immediate change are: New decision­making environment is put in place New optimum might have been miscalculated • We might have to reverse the decision How would ________________________ 39 Immediate v Gradual Change: Depends on the degree of confidence in the estimate of optimum leverage level • The lower the degree ⇒ the slower we change Currently Underlevered Firm Currently Influence of the Industry Average: If the change is: • toward the Industry Average Analysts & rating agencies more likely to be approving Go fast • Away from Industry Average Rating agencies etc __________________ __________________________________ Go slow 40 Likelihood of Takeover (2 slides) • Underlevered firms are more attractive to corporate raiders because they can… Buy firm and increase leverage to fund the takeover • JRJ Nabisco at end of 1980s ____________________________________ 41 Likelihood of Takeover (2) • • Threat of takeover ⇑ then increase leverage faster Threat of takeover ⇓ if… Antitakeover laws are in place Company Articles of Association etc have anti­ takeover provisions Poison pills exist in management contracts etc Company is very large ________________________________ 42 The Four Paths to Optimum (1a) IMMEDIATE Recapitalisation “Leveraged Recapitalisations” • Designed to increase the Debt Ratio fast • May be restricted by bond covenants Issue new debt to retire some equity (via big dividend or Share buyback) • May be good response to takeover threat • Maybe shareholders are offered ____________________________________________ Debt­for­Equity Swap 43 The Four Paths to Optimum (1b) IMMEDIATE Recapitalisation to REDUCE Debt ratio Issue new equity to retire some existing debt _________________________________ • Default risk as bargaining chip Lenders prefer to take on equity than lose investment entirely. • A lot of this happening at present 44 The Four Paths to Optimum (2) IMMEDIATE Divestiture and Use of Proceeds Sell off assets and use cash… Choose assets earning less than their required returns (WACC) But _________________________________ …using the cash: • Overlevered firm may retire debt • Underlevered firm may buy back equity 45 The Four Paths to Optimum (3) GRADUAL (3) Financing of New Assets Underlevered firm might use much higher debt ratio to finance new asset Overlevered firm does opposite • Company (overall) debt ratio rises more modestly • Company (overall) debt ratio falls more modestly New assets also increase firm value irrespective of financing mix • If ___________________________________________ 46 The Four Paths to Optimum (4) GRADUAL (4) Change Dividend Payout Ratio Decreased payout ⇒ more cash available for retiring debt each period. Increased payout ⇒ • Decreases growth rate (g) attributable to internal equity • Need for external financing for projects ⇑ ⇒ Debt Ratio ⇑ (as RE ⇓ ) over time • Ie, more of ___________________________________ 47 Choice of Path Depends on: Urgency of shift to optimum debt ratio Quality of new investments available Marketability of existing investments • Is divestment ____________________________________ 48 ...
View Full Document

This note was uploaded on 12/23/2009 for the course BCOM FINC 202 taught by Professor Warwickanderson during the Spring '09 term at Canterbury.

Ask a homework question - tutors are online