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Today

Capital structure

•M&M theorem •Leverage, risk, and WACC •Taxes and Financial distress,

Reading

• Brealey and Myers, Chapter 17, 18

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Financing decisions

Key goal

•Ensure that funds are available for positive NPV projects, now and in the future •Signaling, taxes, mispricing, issue costs, and corporate control also important

Observations

•Firms follow a pecking order •Different industries seem to have different target debt ratios •Stock issues are bad news, but debt issues are either neutral or good news

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Financial DecisionsTwo models

•Pecking-order theory Firms are worried primarily about selling undervalued shares. They sell equity only when they have no other choice, and there isn’t a specific target debt ratio.

•Trade-off theory Firms care mostly about taxes and distress costs. The tax benefits of debt dominate at low leverage, while distress costs dominate at high leverage. This trade-off leads to an optimal capital structure.

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Trade-off theory

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Financing decisions

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M&M Theorem

Why is MM useful?

•It tells us what is important … Does debt affect investment decisions? Does debt affect taxes? Can equity be issued at fair value? Are transaction costs or bankruptcy costs important?

Impact of debt on ROE and risk Cost of debt relative to the cost of equity (rD vs. rE)

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MM Theorem, cont.

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MM Theorem, cont.

Message 2

In general, financial transactions don’t create or destroy value as long as securities are sold at fair value.

[Unless they affect taxes, investment decisions, etc.]

Example

Your firm needs to raise $100 million. Does it matter whether you decide to issue debt or equity?

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Example

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MM Theorem, cont.

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MM Theorem, cont.

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Example

Your firm is all equity financed and has $1 million of assets and 10,000 shares of stock (stock price = $100). Earnings before interest and taxes next year will be either $50,000, $125,000, or $200,000 depending on economic conditions.

The firm is thinking about a leverage recapitalization, selling $300,000 of debt and using the proceeds to repurchase stock. The interest rate is 10%.

How would this transaction affect the firm’s EPS and cashflows to stockholders? Ignore taxes.

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Example

Current: A = $1 million; E = $1 million (10,000 shares); D = $0

Recap: A = $1 million; E = $700,000 (7,000 shares); D =$300,000

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Example, cont.

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Leverage, EPS, and ROE

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MM Theorem, cont.

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M&M Theorem, cont.

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Example

Your firm is all equity financed and has $1 million of assets and 10,000 shares of stock (stock price = $100). Earnings before interest and taxes next year will be either $50,000, $125,000, or $200,000. These earnings are expected to continue indefinitely. The payout ratio is 100%.

The firm is thinking about a leverage recapitalization, selling $300,000 of debt and using the proceeds to repurchase stock. The interest rate is 10%.

How would this transaction affect the firm’s EPS and stock price? Ignore taxes.

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Example, cont.

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• How does borrowing affect stock price under no tax?

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Example, cont.

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• Share price does not change!

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Example - Macbeth Spot Removers - All Equity Financed

201510% 5(%) shares on Return

2.001.501.00$.50shareper Earnings

2,0001,5001,000$500Income Operating

D C BA

Outcomes

10,000 $Shares of ValueMarket

$10shareper Price

1,000shares ofNumber

Data

M&M (Debt Policy Doesn’t Matter)

Expected outcome

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• Shareholders would be better off if the company had equal proportions of debt and equity!?

• 10% interest rate debt!

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Example

cont.

50% debt

@10%

M&M (Debt Policy Doesn’t Matter)

3020100%(%) shares on Return

321$0shareper Earnings

500,11,000500$0earningsEquity

500500500$500Interest

000,21,5001,000$500Income Operating

CBA

Outcomes

5,000 $debt of ueMarket val

5,000 $Shares of ValueMarket

$10shareper Price

500shares ofNumber

Data

D

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Leverage increase return on equity!

How about investors buy one share and borrow $10 @10% to buy another share?

M&M (Debt Policy Doesn’t Matter)

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Example - Macbeth’s - All Equity Financed

- Debt replicated by investors

3020100%(%) investment$10 on Return

3.002.001.000 $investment on earningsNet

1.001.001.00$1.0010% @Interest :LESS

4.003.002.00$1.00shares twoon Earnings

DCBA

Outcomes

M&M (Debt Policy Doesn’t Matter)

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Proposition I and Macbeth

• However, share price should be the same!!

2015(%) shareper return Expected

1010($) shareper Price

2.001.50($) shareper earnings Expected Equityand Debt Equal

:Structure Proposed

EquityAll

:StructureCuttent

Macbeth continued

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MM'S PROPOSITION I

If capital markets are doing their job, firms cannot increase value by tinkering with capital structure.

V is independent of the debt ratio.

AN EVERYDAY ANALOGY

It should cost no more to assemble a chicken than to buy one whole.

No Magic in Financial Leverage

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Debt and taxes

Tax effects of financing •Corporate taxes Interest is treated as an expense for corporate tax purposes, dividends are not

•Personal taxes Interest is taxed at the full income tax rate, while equity income is taxed at a lower rate Capital gains and international tax rules

•Overall, debt typically has tax advantages Lower overall taxes

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Example

In 2000, Microsoft had sales of $23 billion, earnings before taxes of $14.3 billion, and net income of $9.4 billion. Microsoft paid $4.9 billion in taxes, had a market value of $423 billion, and had no long-term debt outstanding.

Bill Gates is thinking about a recapitalization, issuing $50 billion in long-term debt (rd = 7%) and repurchasing $50 billion in stock. How would this transaction affect Microsoft’s after-tax cashflows and shareholder wealth?

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Microsoft

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Microsoft

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Debt and taxes

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Debt and taxes

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Leverage and firm value

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Microsoft

In 2000, Microsoft had EBIT of $14.3 billion. Microsoft paid $4.9 billion in taxes, had a market value of $423 billion, and had no long-term debt outstanding. Bill Gates is considering a recapitalization, issuing $50 billion in long-term debt (rd = 7%) and repurchasing $50 billion in stock.

Recapitalization

•Interest expense = $50 × 0.07 = $3.5 billion

•Tax shield = $3.5 × 0.34 = $1.19 billion annually

•PV(tax shields) = 1.19 / 0.07 = 50 × 0.34 = $17 billion*

•VL = Vu + PV(tax shields) = $440 billion

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Microsoft

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Debt and taxes

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Leverage and the cost of capital

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Financing decisions

Advantages of debt

Taxes Signaling Corporate control Lower issue costs

Should firms be 100% debt financed?

What are the costs?

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Financial distress

Financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice.

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Financial distress

•Direct costs •Managers’ time and effort •Legal costs•Professional fees•Administrative costs

•Indirect costs •Foregone positive NPV projects •Loss of competitive position •Lost customers •Lost suppliers •Asset fire sales and liquidation •Loss of interest tax shields

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Summary

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Trade-off theory

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Summary

Financing checklist

•Taxes Does the firm benefit from interest tax shields?

•Signaling and mispricing Is our equity fairly valued? How will investor react?

•Expected distress costs What are our cash needs going forward (FCFs)? Cashflow volatility? How costly is it to cut back on expenditures? Customer and supplier concerns? Is renegotiation possible? Asset sales? Financially strong competitors?

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Summary

Who should have low debt?

•Firms with high costs of financial distress Assets cannot be sold easily, high intangibles, high growth options, time-sensitive investment

•Firms with risky earnings and cashflows High probability of distress

•Firms with financially strong competitors Predatory pricing, exploiting downturns

•Firms with low earnings and cumulative losses Tax shields small

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Summary

Target: Single A rated debt

•Tax shields

•Prob of default and credit spreads: AAA vs. A vs. BBB

•Access to credit markets Regulation International capital markets

•Competitors

•Bond covenants

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Bond ratings

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Bond ratings