Capital Structure Decisions Professor Artur Raviv Kellogg School of Management
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Transcript of Capital Structure Decisions Professor Artur Raviv Kellogg School of Management
Capital Structure Decisions 1
Capital Structure Decisions
Professor Artur Raviv
Kellogg School of Management
Capital Structure Decisions 2
Capital Structure decisions
Discussion Agenda
A. What is Financial Leverage
B. Effects of Leverage
C. Optimal Financing in Perfect Markets
D. Optimal Financing in Imperfect Markets
Capital Structure Decisions 3
What is Financial Leverage
All-equity Firm
A firm that uses only equity to finance operations is called an all equity or an unleveraged firm.Equity Value Debt Value Firm Value
E V=
Capital Structure Decisions 4
What is Financial Leverage
Leveraged Firm
A firm that uses sources of financing other then equity, typically debt, has financial leverage and is called a leveraged firm.
Firm ValueEquity Value Debt Value
D + E V=
Capital Structure Decisions 5
Effects of Leverage
Four important effects of financial leverage:1. Increases expected rates of return on equity and
expected EPS
2. Increases risk of equity: both variance and beta
3. Increases the probability of bankruptcy and expected bankruptcy costs
4. Increases the interest tax shieldWhich effect is positive (improves shareholders welfare)
and which is negative (reduces shareholders welfare)?
Capital Structure Decisions 6
Effects of Leverage
1. Leverage Increases Expected Rates of Returns on Equity and Expected EPS.
Example Consider $100 (all-equity) investment in a house.
Expected return on the house is rEu = 15%.
Expected Net Income is = 15%$100 = $15. To find EPSU, suppose there are “10 $10 shares
outstanding”. Thus, EPSU = $15/10 = $1.5.
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Effects of Leverage
Consider the following Financial EngineeringBorrow (take a mortgage) $90 and invest only $10 in own equity. The borrowing rate is the risk-free rate, rD = 10%. (Now there is only “one $10 share outstanding”.) Expected return to leveraged equity and EPS,
both go up .
Alternatively:
E
Drrrr
r
DUE
UE
LE
LE
)(
%6010
90%)10%15(%15
6$1
6$,%60
10
90%1015
goutstandinshareone
IncomeNetExpectedEPS
InvestmentEquity
IncomeNetExpectedr L
LE
Capital Structure Decisions 8
Effects of Leverage
2. Leverage Increases Risk: Both Variance and Beta.
So far the example looked at expected return of 15%. Suppose the underlying distribution is
30%
0%
.5
.5
Capital Structure Decisions 9
Effects of Leverage
Variability of equity returns in unleveraged firm: In “bad” state equity return is 0%. In “good” state equity return is 30%
Equity returns in unleveraged firm are ± 15% around the mean of 15%.
We have here ”double (to 30%) or nothing (to 0%).”
Capital Structure Decisions 10
Effects of Leverage
Variability of equity returns in Leveraged firm: In “bad” state cash flow to equityholders equal $100 -
$9 - $90 = $1. On $10 investment this gives a return of -90%.
In “good” state cash flow to equityholders equals $130 - $9 - $90 = $31. On $10 investment this gives a return of 210%.
Equity returns in leveraged firm are ± 150% around the mean of 60%.
Volatility far exceeds the ”double or nothing” situation of the unleveraged firm.
Capital Structure Decisions 11
Effects of Leverage
3. Leverage Increases the Probability of Bankruptcy and Expected Bankruptcy Costs.
Probability of Bankruptcy =Probability (EBIT < Interest)
It increases with leverage because interest is increased and EBIT remains the same.
Capital Structure Decisions 12
Effects of Leverage
Bankruptcy Costs Bankruptcy costs = the difference between the
value of the assets before and after bankruptcy. The magnitude of bankruptcy costs depends on the
nature of the firm and its industry. Firms with tangible assets have lower bankruptcy costs than
firms whose assets are intangible. Even absent formal bankruptcy, there are costs of
financial distress. These costs increase with the level of debt.
Capital Structure Decisions 13
Effects of Leverage
4. Leverage Increases the Interest Tax Shield. Interest payments on corporate debt are
deductible from taxable income. Therefore, debt provides a tax shield for corporations.
Capital Structure Decisions 14
Effects of Leverage:Summary
Leverage Increases
1. Equity rate of return and EPS
2. Equity risk
3. Expected bankruptcy cost
4. Tax shields
Impact on Shareholders
1. Positive
2. Negative
3. Negative
4. Positive
The question of optimal leverage is highly controversial. To gain understanding, we start with an idealized world, perfect capital markets.
Capital Structure Decisions 15
Capital Structure Under Perfect Capital Markets - M&M
Perfect Capital Markets are Defined: no taxes; no bankruptcy costs; no transaction costs (buying, selling or issuing
securities); equal access to the markets (information, size,
etc..); price taking.
Capital Structure Decisions 16
Capital Structure Under Perfect Capital Markets - M&M
M&M Proposition 1 Under perfect capital markets capital structure is
irrelevant to firm value the value of the firm is unchanged when proportions of
debt and equity are changed.
VL = VU
Debtlevel
Leveraged Firm value, VL
VU VL
Capital Structure Decisions 17
Capital Structure Under Perfect Capital Markets - M&M
IntuitionSince production decisions are fixed, the total cash flow is unchanged. Different capital structures have different ways of
splitting the same total.
Firm Value Equity Value Debt Value Equity Value Debt Value
$100
$50$50
$80
$20
Capital Structure Decisions 18
Capital Structure Under Perfect Capital Markets - M&M
Conclusion Since firm value does not change with degree of
leverage and since debt is sold in competitive markets for its fair value, equityholders situation is not affected by leverage.
The first two effects of leverage are a perfect wash: The increase in expected return to equity just compensates shareholders for the increased risk.
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Capital Structure Under Imperfect Capital Markets
Tax Consideration - Debt Provides Tax Shield VL= VU + PV of tax shields
• Consider a firm with perpetual debt level D that pays annual interest rate rD.
• Annual interest payment equals rDD
• Annual tax shield equals TrDD
• PV of tax shield equals TrDD/rD = TD
D
VL
VU
VL = Vu + TD
VL = Vu + TD
Capital Structure Decisions 20
Capital Structure Under Imperfect Capital Markets
IntuitionAs debt increases, the government share of the given pie decreases. The figures below assume pre-tax value of $100; thus,
with T = 34%, VU = $66 (first figure on left).Shareholders Government
Debtholders
$34
$66
Shareholders Debtholders
Government
$50
$17$33
Shareholders Debtholders
Government
$80
$7
$13VU = $66 VL = $50 + $33 =
$83
VL = $80 + $13.2 = $93.2
Capital Structure Decisions 21
Capital Structure Under Imperfect Capital Markets
Expected Bankruptcy Costs (EBC)VL= VU + PV of tax shields - EBC
D
VL
VU
VL = Vu + TD
VL = Vu + TD - EBC
D*
VL*
Capital Structure Decisions 22
Capital Structure Under Imperfect Capital Markets
With bankruptcy costs, as debt levels increase the expected value lost due to expected bankruptcy cost increases.
Shareholders Government
Debtholders EBC
$10
$59
Shareholders Debtholders
Government EBC
$30
$20 $42
Shareholders Debtholders
Government EBC
$60$14
$10
$31
$8$16
Riskless Debt Risky Debt Riskier Debt
Capital Structure Decisions 23
Capital Structure Under Imperfect Capital Markets
Firms within an industry tend to have similar debt levels. Different industries tend to have different debt levels.
Examples: In 1981 Chrysler restructured by mainly giving debtholders
equity. Makes sense, given that Chrysler had heavy losses accumulated, so their effective TD was basically zero.
Real-Estate companies tend to use extensive leverage. Makes sense, given that expected bankruptcy cost is very low.
What is the capital structure of McKinsey? Why?
Capital Structure Decisions 24
Capital Structure Under Imperfect Capital Markets
Agency Costs Conflict Between Shareholders and Managers
a) Debt increases the fraction of equity held by managersb) Debt commits the firm to pay out “free cash”. This prevents
“empire building” but may result in under- investment. Conflict Between Debtholders and Equityholders
a) Equityholders may benefit from “going for broke- ”asset substitution.”
b) Equityholders may refuse to contribute additional funds even if the firm has a positive NPV project because the benefits accrue to debtholders - “debt overhang” problem.
Capital Structure Decisions 25
Capital Structure Under Imperfect Capital Markets
Asymmetric Information Capital markets underprice equity issuance since
they view the firm as issuing equity when it is overpriced. This results in “pecking order” theory - issue new securities in order of increasing sensitivity to market valuation (risk free debt, risky debt, convertible debt, and equity as last resort)
Firms issuing debt signal that they are of high quality.
Capital Structure Decisions 26
Capital Structure Under Imperfect Capital Markets
Product/ Input Market Interactions Increase in leverage gives incentive to equityholders to
pursue riskier more aggressive strategies. Also, to avoid bankruptcy, they are pushed toward strategies that generate early cash.
Predation - More highly leveraged firms might be easier predation targets.
Interaction with customers/ suppliers - more debt affects these interactions since customers and suppliers bear the costs of bankruptcy.
Capital Structure Decisions 27
Capital Structure Under Imperfect Capital Markets
Corporate Control Capital structure affects the outcome of takeover
contests and their likelihood through its effect on the distribution of votes. It will affect the fraction of votes owned by large “insiders”.
Debt contracts give various level of control to debtholders (covenants could be very restrictive).
Capital Structure Decisions 28
Capital Structure under Imperfect Capital Markets
Personal Taxation The firm tries to minimize PV of all taxes,
not just corporate. On the personal level, equity has a more favorable treatment than debt thus, offsetting part of debt’s corporate tax advantage.
Capital Structure Decisions 29
Summary of two-day announcement effects associated with exchange offers, security sales with designated uses of funds, and calls of convertible securities. With sources and uses of funds associated, these transactions represent virtually pure financial structure changes.
Type of Transaction Security Issued
Security Retired
Average Sample
Size
Two-Day Announcement Period Return
LEVERAGE-INCREASING TRANSACTIONS
Stock Repurchase Exchange Offer Exchange Offer Exchange Offer Exchange Offer
Debt Debt
Preferred Debt
Income bonds
Common Common Common Preferred Preferred
45 52 9
24 24
21.9% 14.0 8.3 2.2 2.2
TRANSACTIONS WITH NO CHANGE IN LEVERAGE
Exchange Offer Security Sale
Debt Debt
Debt Debt
36 83
0.6* 0.2*
LEVERAGE-REDUCING TRANSACTIONS
Conversion-Forcing Call Conversion-Forcing Call Security Sale Exchange Offer Exchange Offer Security Sale Exchange Offer
Common Common
Convertible debt Common Preferred Common Common
Convertible preferred Convertible bond
Debt Preferred
Debt Debt Debt
57 113 15 30 9
12 20
-0.4* -2.1 -2.4 -2.6 -7.7 -4.2 -9.9
*Not statistically different from zero. Source: C. W. Smith, "Investment Banking and the Capital Acquisition Process," Journal of Financial Economics, 1986, p. 12.