CAPITAL STRUCTURE

DECISIONS
ADVANCED FINANCIAL MANAGEMENT
USMAN RASHEED
Terminologies

 V = value of firm
 FCF = free cash flow
 WACC = weighted average cost of capital
 rs – Cost of Stock/Equity (return)
 rd - Cost debt (return)
 ws and wd are percentages of the firm that are financed with stock
and debt.
How can capital structure affect
value?

∞ FCFt
V = ∑
t= (1 +
1 WACC)t
WACC= wd (1-T) rd + wsrs
How can capital structure affect
value?

The impact of capital structure on value depends

upon the effect of debt on:
 WACC

 FCF
The Effect of Additional Debt on
WACC

 Debtholders have a prior claim on cash flows relative to

stockholders.
 Debtholders’ “fixed” claim increases risk of stockholders’ “residual”
claim.
 Cost of stock, rs, goes up.
 Firm’s can deduct interest expenses.
 Reduces the taxes paid
 Frees up more cash for payments to investors
 Reduces after-tax cost of debt
The Effect of Additional Debt on
WACC

 Debt increases risk of bankruptcy

 Causes pre-tax cost of debt, rd, to increase
 Adding debt increase percent of firm financed with low-
cost debt (wd) and decreases percent financed with high-
cost equity (ws)
 Net effect on WACC = uncertain.
The Effect of Additional Debt on
WACC

 Debt increases risk of bankruptcy

 Causes pre-tax cost of debt, rd, to increase

 Adding debt increase percent of firm financed with low-

cost debt (wd) and decreases percent financed with high-
cost equity (ws)

 Net effect on WACC = uncertain.

The Effect of Additional Debt on
FCF
 Additional debt increases the probability of bankruptcy.
 Direct costs: Legal fees, “fire” sales, etc.
 Indirect costs: Lost customers, reduction in productivity of managers
and line workers, reduction in credit (i.e., accounts payable) offered
by suppliers

 Impact of indirect costs

 NOPAT goes down due to lost customers and drop in productivity
 Investment in capital goes up due to increase in net operating
working capital (accounts payable goes down as suppliers tighten
credit).
The Effect of Additional Debt on
FCF

 Additional debt can affect the behavior of

managers.
 Reductions in agency costs: debt “pre-commits,” or “bonds,”
free cash flow for use in making interest payments. Thus,
managers are less likely to waste FCF on perquisites or non-
value adding acquisitions.
 Increases in agency costs: debt can make managers too risk-
averse, causing “underinvestment” in risky but positive NPV
projects.
Asymmetric Information &
Signaling

 Managers know the firm’s future prospects better than investors.

 Managers would not issue additional equity if they thought the
current stock price was less than the true value of the stock (given
their inside information).
 Hence, investors often perceive an additional issuance of stock as
a negative signal, and the stock price falls
What is business risk?

 Uncertainty about future pre-tax operating income (EBIT).

Probability
Low risk

High risk

0 E(EBIT) EBIT
Note that business risk focuses on operating income, so it ignores
financing effects
Factors That Influence Business
Risk

 Uncertainty about demand (unit sales).

 Uncertainty about output prices.
 Uncertainty about input costs.
 Product and other types of liability.
 Degree of operating leverage (DOL).
What is operating leverage, and
how does it affect a firm’s
business risk?
 Operating leverage is the change in EBIT caused by a
change in quantity sold.
 The higher the proportion of fixed costs within a firm’s
overall cost structure, the greater the operating leverage.
 Higher operating leverage leads to more business risk,
because a small sales decline causes a larger EBIT
decline.
What is operating leverage, and
how does it affect a firm’s
business risk?
 Higher operating leverage leads to more business risk,
because a small sales decline causes a larger EBIT decline.

$ Rev. $ Rev.
TC }EBIT
TC
F
F

QBE Sales QBE Sales

 Degree of Operating Leverage

 John’s Software is a leading software business, which mostly incurs fixed costs
for upfront development and marketing. John’s fixed costs are $780,000, which
goes towards developers’ salaries and the cost per unit is $0.08. The company
sells 300,000 units for $25 each. Given that the software industry is involved in
the development, marketing and sales, it includes a range of applications, from
network systems and operating management tools to customized software for
enterprises.

DOL = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Op. Costs
 Example

DOL = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Op. Costs

= [300,000 x (25-0.08)] / (300,000 x (25-0.08) – 780,000 = 7,476,000 / 6,696,000 = 112% or 1.12.

This means that a 10% increase in sales will yield a 12% increase in profits

If the company increase sales to, let’s say, 450,000 units for $20 each, the new DOL will be ?
[450,000 x (20-0.08)] / (450,000 x (20-0.08) – 780,000 = 8,964,000 / 8,184,000 = 110% or 1.10

This means that a 10% increase in sales will yield an 11% increase in profits (10% x 11 = 110%), but the
company generates $1,527,000 more in sales revenues (8,964,000 -7,437,000 = 1,527,000).
Note that costs remain unchanged and only by lowering the price the company increases its sales revenues.
Operating Breakeven

 Q is quantity sold, F is fixed cost, V is variable cost,

TC is total cost, and P is price per unit.
 Operating breakeven = QBE
QBE = F / (P – V)

Example:
F=$200, P=$15, and V=$10:
QBE = $200 / ($15 – $10) = 40.
Business Risk versus Financial
Risk

Business risk:
 Uncertainty in future EBIT.
 Depends on business factors such as competition,
operating leverage, etc.

Financial risk:
 Additional business risk concentrated on common
stockholders when financial leverage is used.
 Depends on the amount of debt and preferred stock
financing.
Consider Two Hypothetical Firms

Firm U Firm L
Capital $20,000 $20,000
Debt $0 $10,000 (12%
rate)
Equity $20,000 $10,000
Tax rate 40% 40%
EBIT $3,000 $3,000
. NOPAT $1,800 $1,800
ROIC 9% 9%
Impact of Leverage on Returns

Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080

ROIC (NI+Int)/TA] 9.0% 11.0%

ROE (NI/Equity) 9.0% 10.8%
Why does leveraging increase
return?

More EBIT goes to investors in Firm L.

Total dollars paid to investors:

U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
Taxes paid:
U: $1,200; L: $720.
Equity $ proportionally lower than NI.
EBIT Uncertain

Now consider the fact that EBIT is not known

with certainty.

What is the impact of uncertainty on

stockholder profitability and risk for Firm U and
Firm L?

Continued…
 Compariso
n
Firm U: Unlevered
Firm L: Levered
Economy Economy

Prob. 0.25 Bad

0.50 Avg. 0.25 Bad
0.50 Avg.
0.25
0.25 Good $2,000 Good
$3,000 $4,000
EBIT $2,000 $3,000 1,200 1,200 1,200
$4,000 $ 800 $1,800 $2,800
Interest 0 0 320 720 1,120
0 $ 480 $1,080 $1,680
Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
TIE n.a. n.a. n.a.

Firm L Bad Avg. Good

BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
Comparison

Profitability Measures:
U L
E(BEP) 15.0% 15.0%
E(ROIC) 9.0% 9.0%
E(ROE) 9.0% 10.8%

Risk Measures:
ROIC 2.12% 2.12%
ROE 2.12% 4.24%
 Conclusion

 Basic earning power (EBIT/TA) and ROIC (NOPAT/Capital = EBIT(1-T)/TA)

are unaffected by financial leverage.
 L has higher expected ROE: tax savings and smaller equity base.
 L has much wider ROE swings because of fixed interest charges.
Higher expected return is accompanied by higher risk.
 In a stand-alone risk sense, Firm L’s stockholders see much more
risk than Firm U’s.
 U and L: ROIC = 2.12%. U: ROE = 2.12%. L:
ROE = 4.24%.
 L’s financial risk is ROE - ROIC = 4.24% - 2.12% = 2.12%. (U’s is zero.)
 Conclusion

 For leverage to be positive (increase expected ROE), BEP

must be > rd.

 If rd > BEP, the cost of leveraging will be higher than the

inherent profitability of the assets, so the use of financial
leverage will depress net income and ROE.

 In the example, E(BEP) = 15% while interest rate = 12%,

so leveraging “works.”
Capital Structure Theory

MM theory (The Modigliani and Miller Models)

 Zero taxes
 Corporate taxes
 Corporate and personal taxes
 Trade-off theory
 Signaling theory
 Pecking order
 Debt financing as a managerial constraint
 Windows of opportunity
MM Theory – Zero Taxes

Firm U Firm L
Under the assumptions of
EBIT $3,000 $3,000 (1) no transactions costs;
Interest 0 1,200 (2) no restrictions or costs to
short sales; and
(3) individuals can borrow at
NI $3,000 $1,800 the same rate as corporations
MM prove that if the total
CF to investors of Firm U
CF to $3,000 $1,800 and Firm L are equal, then
the total values of Firm U
shareholder and Firm L must be equal
CF to 0 $1,200
debtholder
MM Theory – Zero Taxes

MM prove, under a very restrictive set of assumptions that a firm’s

value is unaffected by its financing mix:
V L = V U.
► Because FCF and values of firms L and U are equal, their WACCs are equal.
► Therefore, capital structure is irrelevant
► Any increase in ROE resulting from financial leverage is exactly offset by
the increase in risk (i.e., rs), so WACC is constant.
MM Theory – Corporate Taxes

Firm U Firm L Plan U has $3000 of net income

EBIT $5,000 $5,000 for shareholders, but
Plan L has $400 of interest for
Interest 0 (400) debt holders and $2760 of net
Pre-Tax Earnings $5,000 $4,600 income for shareholders for a
combined total of $3160,
Tax 40% (2000) (1,840) which is exactly $160 more than
NI after Tax $3,000 $2,760 Plan U.
With more cash flows available
The extra 3000–2760=160 amount is paid out to
investors for investors, a levered firm’s
total value should be greater
V = V + Present value of tax shield
L U
than that of an unlevered firm
V =IfVT =+40%,
L U TD then every dollar of debt adds 40 cents of extra
value to firm.
Miller’s Theory: Corporate &
Personal Taxes

Personal taxes lessen the advantage of corporate debt:

► Corporate taxes favor debt financing since corporations

can deduct interest expenses.

► Personal taxes favor equity financing, since no gain is

reported until stock is sold, and long-term gains are
taxed at a lower rate
Miller’s Theory: Corporate &
Personal Taxes
Miller’s Model with Corporate and Personal
Taxes

(1 - Tc)(1 - Ts)
VL = VU + 1− D
(1 - Td)
Tc = corporate tax rate.
Td = personal tax rate on debt
income.
Ts = personal tax rate on stock
 Miller’s Theory: Corporate &
Personal Taxes
Tc = 40%, Td = 30%, and Ts = 12%.

(1 - Tc)(1 - Ts)
VL = VU + 1− D
(1 - Td)
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $1 increase in debt raises L’s value
by $0.25.
The presence of personal taxes reduces but does not
completely eliminate the advantage of debt financing
 Bankruptcy & Financial Distress

 When companies can't pay their debts, they may have very limited options for their
future.
 One of those options may be bankruptcy, a process of freeing a company of its debts and
other obligations, while giving creditors an opportunity for repayment. While it is a last
resort, bankruptcy can give companies a fresh start.
 Bankruptcy costs vary depending on the structure and size of the company. They
generally include filing fees, legal and accounting fees, the loss of human capital, and
losses from selling distressed assets.
 Bankruptcy usually happens when a company has far more debt than it
does equity.
 The threat of bankruptcy, not just bankruptcy per se, causes financial distress costs.
 Results in key employees jump ship, suppliers refuse to grant credit, customers seek more
stable suppliers, and lenders demand higher interest rates and impose more restrictive
loan covenants if potential bankruptcy looms.
Trade-off Theory

A company financing decision (Debt Equity ratio) is determined by the

achievement of balance between tax benefits and costs.
Companies substitute debt with equity or equity with debt until the value
of the firm is maximized

► MM theory ignores bankruptcy (financial distress) costs, which increase

as more leverage is used.

► At low leverage levels, tax benefits outweigh bankruptcy costs.

► At high levels, bankruptcy costs outweigh tax benefits.

► An optimal capital structure exists that balances these costs and benefits.
Signaling Theory (market timing
theory)
MM assumed that investors have the same information about a firm’s prospects
as its managers symmetric information. However, managers in fact often
have better information than outside investors asymmetric information, and
it has an important effect on the optimal capital structure.
► Example – Firm with Positive Prospects & Firm with Negative Prospects
► Firms with extremely bright prospects prefer not to finance through new stock
offerings, whereas firms with poor prospects like to finance with outside
equity.
► How should you, as an investor, react to this conclusion?
► The announcement of a stock offering is generally taken as a signal that the
firm’s prospects as seen by its own management are not good.
► This is the essence of the capital structure signaling theory, which suggests
that firms should issue debt rather than stock.
Signaling Theory (market timing
theory)
 The signaling theory originates from information asymmetries
between firm management and shareholders

 Signaling theory is the belief that information on a company's

financial health is not available to all parties in a market at
the same time

 Signaling theory assumes that there is asymmetric information

because managers have more complete information than investors. A
stock issue is viewed as a negative signal, whereas a
debt/bond issue is a neutral (or small negative) signal
Reserve Borrowing Capacity

 Issuing stock sends a negative signal and tends to depress the

stock price even if the company’s true prospects are bright, a
company should try to maintain a reserve borrowing capacity
so that debt can be used if an especially good investment
opportunity comes along.

 This means that firms should, in normal times, use more equity
and less debt than is suggested by the tax benefit–bankruptcy
cost trade-off model.
Pecking Order Theory

 Firms use internally generated funds first (by

reinvesting its net income and selling its short-term marketable
securities etc.),
because there are no flotation costs or
negative signals.

 If more funds are needed, firms then issue debt

because it has lower flotation costs than equity and
not negative signals.

 If more funds are needed, firms then issue equity.

Debt Financing and Agency
Costs

► One agency problem is that managers can use corporate funds for
non-value maximizing purposes.
► The use of financial leverage (debt):
► Bonds “free cash flow.”
► Forces discipline on managers to avoid perks and non-value
adding acquisitions.

► A second agency problem is the potential for “underinvestment”.

► Debt increases risk of financial distress.
► Therefore, managers may avoid risky projects even if they have positive
NPVs
The Market Timing Theory

 If markets are efficient, then security prices should reflect all

available information; hence, they are neither underpriced nor
overpriced.

 The market timing theory states that managers don’t believe this
and supposes instead that stock prices and interest rates are
sometimes either too low or too high relative to their true
fundamental values.

 Managers issue equity when they believe stock market prices are
abnormally high and issue debt when they believe interest rates are
abnormally low. In other words, they try to time the market.1
Implications for Managers

 Managers should explicitly consider tax benefits when making capital structure
decisions.
Tax benefits obviously are more valuable for firms with high tax rates
 Managers should also consider the expected cost of financial distress, which depends
on the probability and cost of distress. Notice that stable sales and lower operating
leverage provide tax benefits but also reduce the probability of financial distress
 Managers should consider conditions in the stock and bond markets.
Credit Crunch -> no market at reasonable interest rate for Low rating bonds
-> Low rated Co. in need of capital were forced to go to the stock market/STdebt
market, regardless of their target capital structures
 Finally, managers should always consider lenders’ and rating agencies’ attitudes.
Estimating the Optimal Capital
Structure

 Managers should choose the capital structure that maximizes shareholders’ wealth.
 The basic approach is to consider a trial capital structure, based on the market values of
the debt and equity, and then estimate the wealth of the shareholders under this capital
structure.
 This approach should be repeated until an optimal capital structure is identified.
There are several steps in the analysis of each potential capital structure:
(1) Estimate the interest rate the firm will pay.
(2) Estimate the cost of equity.
(3) Estimate the weighted average cost of capital.
(4) Estimate the value of operations, which is the present value of free cash flows
discounted by the new WACC.
The objective is to find the amount of debt financing that maximizes the value of
operations.
Example

Is this the optimal capital structure?

1.Estimate the cost of equity using CAPM rs = rRF
+ b(RPM)
2.The weighted average cost of capital is: WACC =
wd(1-T)rd + ws rs
Example
Estimating Optimal Capital
Structure
 Estimating WACC for Different
Levels of Debt
Following is a description of the steps to estimate the weighted
average cost of capital for different levels of debt
 ESTIMATING THE COST OF DEBT (rd)
 ESTIMATING THE COST OF EQUITY (rs) WITH THE HAMADA EQUATION
 An increase in the debt ratio also increases the risk faced by shareholders,
and this has an effect on the cost of equity, rs.
 Hamada equation specifies the effect of financial leverage on beta
 Often we know the current capital structure and beta but wish to know the
unlevered beta.
 THE WEIGHTED AVERAGE COST OF CAPITAL AT DIFFERENT LEVELS OF DEBT
 Use the Hamada equation to calculate the unlevered beta for JAB
Industries, assuming the following data: Levered beta b 1 4; T 40%; wd
45%.

 Suppose rRF 6% and RPM 5%. What would be the cost of equity for JAB
Industries if it had no debt? If wd were 45%?
Estimating Optimal Capital
Structure