Unformatted text preview: Capital Structure Decisions
Readings: Text Chapter 13 Overview
Assets Current Assets Cash Receivables Inventories Other Long-Term Assets PPE Net Notes Rec.Affl. Joint Ventures Goodwill Reaq.Franchises Other 21,029 68,666 28,864 20,085 138,644 284,716 7,609 12,426 19,865 174,537 22,867 522,020 660,664 Liabilities Current Liabilities Accounts Payable Accrued & Other Current LT Debt 19,107 31,525 2,861 53,493 6,417 87,000 48,056 11,168 152,641 294,477 157,730 452,207 660,644 LT Liabilities Deferred Taxes Revolving Credit LT Debt (net) Other Shareholders Equity Par Value Retained Earning Total Liabilities Total Assets Some of Krispy Kreme's Decisions 4/5/2000: IPO of 3.45m shares @ $21, total of 26.8m shares. No Dividend so all Income plowed-back into Retained Earning (2000: $5.9m, 2001: $14.7m, 2002: $26.4m, 2003: $39.1m, 2004: $56.8m, 2005: -$198.3m, 2006: -$135.8m, 2007: -$42.2m) 2/5/2001: Follow-on stock offering (SEO), 10.4m shares sold but 9.3m were insider shares. Total raised by KK was $17.2m. 6/14/2001 2:1 stock split 10/31/2003: $150m credit facility established - $87m drawn. 4/4/2005: New $225m credit facility established $90m used to retire old credit facility. Feb 16, 2007 new $160 million credit facility - bears interest at LIBOR plus 3.00% (subject to a stepdown based on credit ratings), compared to LIBOR plus 5.875% under the retired term loan.. Tradeoff Theory
(M&M Irrelevance Hypothesis) Assume:
1. 2. 3. 4. 5. No income taxes. No transactions costs to issue securities. Investors can borrow at same rate as firms. No costs of financial distress. Symmetric information. Under these assumptions, firm value is independent of Capital Structure. M&M Irrelevance by Example
Assume Two equivalent firms Firm A: Expected earnings per year = $10m in perpetuity, 100% equity, ks=10%. Firm B: Expected earnings per year = $10m in perpetuity, financed with equity and $50,000,000 of debt with coupon rate c = 6%. All earnings paid out as dividends for both firms. What is the market value of firm A? Div V = k -g Example (II)
What are earnings available to firm B shareholders after interest payments? Assume: Market value of firm B's equity is $70m Total market value is $70m+$50m = $120m These values can't be "right" since they would generate an arbitrage opportunity. Example (III)
Law of one price: Two "securities" generating the same cash flows must sell for the same price. Sell short 1% of firm B's equity, buy 1% of firm A's equity, and borrow $500,000 in perpetuity at 6%
Cash Flow Now Annual Cash Flow in Future Short sell 1% equityB Buy 1% equityA Borrow $500,000 @ krf Total of all transactions Example (III)
What if firm B's equity was worth $40m? purchase 1% of firm B's equity and debt while selling short 1% of firm A's equity
Cash Flow Now Short sell 1% equityA Buy 1% equityB Buy 1% debtB Total of all transactions Annual Cash Flow in Future Implications For ks and WACC
Assume that firm A has 1,000,000 shares outstanding and B has 500,000 shares. (This simply makes each sell for $100) EPSA = $10m/1m = $10 per share EPSB = ($10m-$3m)/.5m = $14 per share Solve for ks: Div V = k -g Implications For ks and WACC (II)
Solve for WACC (remember, no taxes): WACC = wd k d (1 - t ) + w ps k ps + ws k s Same as for firm A! Cost of Capital - Graphically
Cost of Capital (%) Debt/Equity Ratio (Note that debt is riskless if kd * D < $5m) Conservation of Value and Risk
Key Implications of Irrelevance Hypothesis: Firm Value is independent of capital structure. WACC is independent of capital structure. and ks increase with leverage. Value and risk are "conserved". The Pizza Pie Analogy D
E E Firm B Firm A Why Exactly Does ks Increase with Leverage?
Assume that the profits of A and B are:
State Bad Business Normal Business Good Business Mean EBIT $5m $10m $15m $10m EPSA $5 $10 $15 $10 $4.08 EarningsB $2m $7m $12m $7m EPSB $4 $14 $24 $14 $8.17 Variability in EBIT: function of Business Risk: Cyclicality of industry. Product diversification. Operating leverage. Degree of competition. Additional variability in EPSB is a function of financial risk (leverage). M&M & the Real World
Taxes are a fact of life. Interest payments are tax deductible. There are costs of financial distress. Asymmetric information is a problem. Assume Corporate Income Tax = 40%:
Firm A: After Tax CF = EBIT * (1-t) Firm B: After Tax Earnings = (EBIT-I)*(1-t) After Tax CF = (EBIT-I)*(1-t) + I M&M & the Real World (II)
State Bad Business EBIT Firm A: After Firm B: After Firm B: Tax CF tax Earnings After Tax CF $5m $15m $3m $6m $9m $1.2m $4.2m $7.2m $4.2m $7.2m $10.2m Normal Business $10m Good Business Value of "Slices" With Taxes
Firm A: Market Value Equity: $6m/.10 = $60m PV of Tax Perpetuity: $4m/.10 = $40m Firm B: Market Value of firm = $60m + $1.2m/.06 = $80m Market Value Debt: $3m/.06 = $50m Market Value Equity: $80m - $50m = $30m PV of Tax Perpetuity: $100m - $80m = $20m Value of "Slices" With Taxes
The difference in total firm market values is known as the Present Value of the Interest Tax Shield. Pizza Pie Analogy Revisited tax E E D tax Firm A Firm B Example
Assume: EBIT is $1,000 in perpetuity 100 shares of stock Marginal tax rate = 35% ks if all equity financed = 12% What is the value of the firm? Example Continued
Assume that $3,000 of perpetual debt with a coupon rate of 8% is issued with the proceeds used to repurchase shares. What is the new value of the firm and price per share? So All Firms Should Have Lots of Debt Right?
1984 Internet Computers Chemical Man. Food Man. Paper Man. Air Transport Truck Transport Utilities Textile Mills Hotels 5% 9% 14% 17% 19% 37% 22% 34% 26% 41% 1990 2% 15% 16% 17% 25% 26% 27% 32% 42% 51% 1996 3% 7% 13% 18% 22% 24% 26% 28% 39% 38% 2001 1% 9% 17% 21% 33% 28% 27% 32% 35% 44% Why is leverage moderate and why is there so much cross-sectional variation? Costs of Financial Distress Potential Financial Distress Costs:
Reputational Problems Reductions in Credit Disputes between stakeholders Legal fees Extra time spent dealing with these problems How Costly is Financial Distress?
Study of 31 highly levered firms (MBO or leveraged recap from 1980-1989) that defaulted on debt or attempted to restructure. Authors measured firm value 2 months prior to event and as soon as possible after resolution of problems. 16 firms at exit from Ch. 11 8 firms following recap via fresh IPO 5 firms sale of company 1 firm liquidation Median value loss is about 20%. Additional Costs (+Benefits) of Debt
Agency Costs of Debt
High levels of leverage may induce managers to make inappropriate decisions. Need for monitoring by debtholders increases with leverage. Agency Benefits of Debt:
Forces payout of cash. Incentive to management to work hard. Determining Your Debt Capacity
Will more debt substantially increase the probability that firm cannot make required payments? Level of Earnings Before Tax. Variability in Earnings Before Tax. Affected by operating leverage. If firm gets in financial distress, will significant value be lost? Access to capital market. Growth (need for continued financing) Collateralizability of assets. Degree of competition. Reputational concerns. Optimal Capital Structure (I)
Value of the Firm as a Function of Capital Structure (with Corporate Income Tax, Financial Distress Costs, and Agency Costs) Is That It?
Everything discussed thus far is characterized as Static Trade-off Theory: Each firm has an optimal capital structure where Firm value is maximized, WACC is minimized Marginal cost of debt = marginal benefit Firms have no reason to stray from their optimum once they attain it. Firms will take action to reduce debt when leverage is too high and increase debt when leverage is too low. One Additional Complication Asymmetric Information ....Akerlof's Lemons Problem. Assume a firm is attempting to increase equity capitalization from $1 billion to $1.1 billion via a Seasoned Equity Offering (SEO). What will typically happen to share price at announcement?
Is this effect big enough to matter? Is the same effect likely if the firm decides to raise $100 million via a debt issue? Is the same effect likely if the firm announces an intention to use $100 million of internal cash rather than returning it to shareholders? Result: The Pecking Order Most firms state that they do have an optimal (static) capital structure. However, firms are typically very cautious and stockpile resources (reduce leverage) to avoid having to issue equity in a pinch. The Pecking Order: Firms rely as much as possible on retained earnings (internal finance). First recourse for outside finance is usually debt. Firms at their debt capacity may forego investment. Last resort is to pursue an SEO...but evidence also suggests firms "time" the market. Stylized Facts Consistent with Pecking Order
1. Most investment is financed with internal funds. Likelihood of an SEO by an established firm is <2% per year Source of Funds Data (The Pecking Order) Internal ~ 60% Debt Issues ~ 24% Accounts Payable ~ 12% Stock Issues ~ 4% 2. 3. 4. Managers express concern about "maintaining financial flexibility." More profitable firms are usually low leverage. Firms tend to issue stock after price run-ups exactly the opposite of what a "rebalancing" firm would do. Some International Evidence on Leverage
Median Debt to Capital (1995)
45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
Ja pa G er n m an y Fr an ce ng do m Ca na da at es St Ita ly Book Market te d Un i Source: Rajan & Zingales, 1995, What do we know about capital structure? Some evidence from international data, Journal of Finance 50, 1421-1460 Un i te d Ki Summary Leverage increases expected cash flows to equity while at the same time increasing variability (risk) of cash flows. M&M irrelevance: Firm value is independent of leverage. WACC is independent of leverage. ks goes up "enough" to counter increase in expected cash flows. Summary
M&M with real world assumptions: Firm value and WACC change with leverage. Initial increase in firm value (decrease in WACC) is due to tax benefit of debt. Subsequent decrease in firm value (increase in WACC is due to cost of "too much" debt. Firms have an optimal capital structure where marginal benefit of an additional $ of debt = marginal cost. ...
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