Chapter 16
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Chapter 16. Capital Structure. LEARNING OBJECTIVES. 1. Explain why borrowing rates are different based on ability to repay loans. 2. Demonstrate the benefits of borrowing. 3. Calculate the break-even EBIT for different capital structure.

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Chapter 16

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Chapter 16

Chapter 16

Capital Structure


Chapter 16

LEARNING OBJECTIVES

  • 1. Explain why borrowing rates are different based on ability to repay loans.

  • 2. Demonstrate the benefits of borrowing.

  • 3. Calculate the break-even EBIT for different capital structure.

  • 4. Explain the appropriate borrowing strategy under the pecking order hypothesis.

  • 5. Define optimal borrowing in a world of no taxes.

  • 6. Explain the static theory of capital structure.


Chapter 16 using other people s money

Chapter 16: Using other people’s money

  • Why do we borrow?

    • Consume today on future income

    • Households currently have almost $16 trillion in outstanding loans

  • Does it matter where we get our money?

    • What makes a good source of funds when we borrow?

      • Lowest cost for funds

      • Implicit costs can be very expensive

  • Is there an optimal borrowing strategy?

    • Reduce overall costs with a different borrowing pattern


16 1 capital markets

16.1 Capital Markets

  • In the corporate world…two major markets for borrowing

    • From banks and bond markets – Debt Markets

    • From owners – Equity Markets

  • Borrowers get different rates from these two markets

    • Debt market – different yield to maturities on bonds

    • Debt market – different loan rates from banks

    • Equity market – different return rates for stocks

    • Ability to pay back loan impacts the rate

    • Lenders (and owners) look at the future cash flow


16 1 capital markets1

16.1 Capital Markets

  • Different Rates for Different Borrowers

    • Success rate for Angel Investors – impact returns

    • Example 16.1 in the book Larry and Sherry

      • Larry is successful on four in ten investments

      • Sherry is successful on one in ten investments

    • Required Return on $1,000,000 ($100,000 for each of ten projects)

      • Larry gets four to payback…each must pay $250,000 so rate is ($250,000 - $100,000) / $100,000 = 150%

      • Sherry gets only one to payback…it must pay $1,000,000 so rate is ($1,000,000 - $100,000) / $100,000 = 900%


16 2 benefits of borrowing

16.2 Benefits of Borrowing

  • Who would every pay Sherry 900% on a loan?

    • You have a project with a 25% chance of making $5,000,000 and a 75% chance of making $0

    • No banks or friends will loan you the money

    • Sherry offers 900% rate for the needed $100,000 investment

    • Do you take the loan?

  • Expected Payoff…

    • 25% x $5,000,000 - $1,000,000 = $250,000

    • But…either you make $4,000,000 or you lose $100,000

  • Financial Leverage…using other people’s money


16 2 benefits of borrowing1

16.2 Benefits of Borrowing

  • How do we measure financial leverage in a company?

    • Leverage is the amount of debt borrowed versus the amount of funds from the owners

    • Highly leveraged firms have high Debt to Equity ratios

    • Unlevered firms use only equity financing

  • How do we measure the benefits to a company from debt borrowing?

    • Earnings Per Share

    • Does borrowing increase or decrease the owner’s wealth?


16 2 benefits of borrowing2

16.2 Benefits of Borrowing

  • Page 494-497

    • Three companies with different Debt / Equity Ratios

    • Company 1 is unlevered (all equity, 400 shares)

    • Company 2 is 50 / 50 debt and equity (200 shares)

    • Company 3 is levered to the max (1 share)

  • High EBIT -- $2,000 Company 3 structure is best

  • Low EBIT -- $800 Company 1 structure is best

  • At $1,000 – All have the same Earnings Per Share

    • Capital Structure is irrelevant at $1,000


16 3 find the break even ebit

16.3 Find the Break-Even EBIT

  • Can only find this in a pair-wise fashion (can only compare two firms at a time)

    • Set EPS calculation equal under the two structures

    • Company 1 EPS = EBIT / 400

    • Company 2 EPS = (EBIT - $500) / 200

    • Company 1 EPS = Company 2 EPS, solve for EBIT

  • This in a world of no taxes…

  • Above the Break-Even EBIT more leverage (more debt) is better for the owners.


16 4 pecking order hypothesis

16.4 Pecking Order Hypothesis

  • Borrow from the cheapest source first

    • Once the source is “exhausted” move to the second cheapest source

    • Continue to additional sources as needed for funding once each level is “exhausted”

  • This borrowing hypothesis is based on asymmetric information

    • One set of agents (company managers and owners) know more about the future cash flow prospects of the company than the lending agents

  • Firms Prefer Internal Financing First

  • Firms Choose to Issue the cheapest security first

  • Firms Use Equity as a Last Resort


Chapter 16

16.4 Pecking Order Hypothesis

  • Example 16.3 Rogen vs. Rudd Corporations

    • Facts: Outsiders think that the stock could go as high as $50 or as low as $35 but it now is fairly valued at $42

    • Rogen CEO knows the company has a major break-through and stock will climb to $50

      • However the information is proprietary

    • Rudd CEO knows they have a new product too but, will not cause a rise in stock prices

      • Competitors will be able to quickly imitate new product


16 4 pecking order hypothesis1

16.4 Pecking Order Hypothesis

  • How do you finance the needed $50 million?

    • Rogen CEO cannot tell public about product and will not sell equity below the new $50 value once the product is released (transfer of wealth from original owners to new owners) as the new owners will only pay $42 a share without the inside information

    • Rogen CEO thus chooses to use debt to avoid wealth transfer

    • Rudd CEO knows stock is worth $42 but if he chooses to sell equity the market will pay only $35. New owners believe that Rudd would only sell equity if it is overpriced, thus the $35 is the correct price

    • Rudd CEO thus chooses to use debt to avoid wealth transfer


16 4 pecking order hypothesis2

16.4 Pecking Order Hypothesis

  • Conclusion

    • Profitable companies will borrow less and signal more debt capacity

    • Less profitable companies need more outside funding and will first seek debt (avoiding wealth transfer)

    • As a last resort, companies will sell equity

  • While this Hypothesis has some support, we see many companies use debt when they have internal funding…


16 5 modigliani and miller on optimal capital structure

16.5 Modigliani and Miller on Optimal Capital Structure

  • Start with the simplest world…no taxes and no bankruptcy (firms never default)

    • M&M Proposition 1 – Capital Structure is irrelevant

      • Value of an all equity firm (VE) is equal to the value of a leveraged firm (VL)

      • Think of two pies of equal size, the value (volume) of the pie does not change when we cut it into smaller pieces

    • M&M Proposition 2 – A firm’s value is based on

      • The required rate of return

      • The cost of Debt

      • The firm’s debt-to-equity ratio


16 5 modigliani and miller on optimal capital structure1

16.5 Modigliani and Miller on Optimal Capital Structure

  • The math…

    • WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc )

    • The required return on the assets, Ra, is equal to WACC

    • Ra =(E/V) x Re+ (D/V) x Rd

    • In a world of no taxes, the required return on assets is the weighted average of equity and debt

    • Re =Ra + (Ra –Rd) x (D/E)

  • The visual…page 504 Figure 16.3


16 5 modigliani and miller on optimal capital structure2

16.5 Modigliani and Miller on Optimal Capital Structure

  • But the world has taxes…so what happens when we add taxes

    • M&M Proposition 1 – with taxes

      • All debt financing is preferred

      • Adding debt reduces the government’s claim to the pie

    • M&M Proposition 2 – with taxes

      • As the firm adds debt the WACC falls

      • There is a tax shield with debt

      • The bigger the debt the greater the tax shield

    • Visual is Pie Charts on page 505


16 5 modigliani and miller on optimal capital structure3

16.5 Modigliani and Miller on Optimal Capital Structure

  • What is the tax shield?

    • The government allows the deduction of interest expense from taxable income (pays part of the interest for the company)

    • The owners of the company claim this tax shield

      • VL = VE + (D x TC)

    • Thus the owner’s value increases as a company adds more debt financing

  • See Figure 16.5 on page 507

    • Optimal Capital Structure is now all debt


16 5 the static theory of capital structure

16.5 The Static Theory of Capital Structure

  • We now relax the last parameter…bankruptcy

    • When a firm borrows “too much” and cash flow is insufficient to cover interest payments

      • The company goes into bankruptcy

      • Technically the debt holders get the company

    • Bankruptcy costs

      • Direct costs are relatively small

      • Indirect costs can be large…takes the managers away from the required tasks and puts the company in financial distress

      • The greater the debt, the greater the chance of financial distress


16 5 the static theory of capital structure1

16.5 The Static Theory of Capital Structure

  • As a firm starts to add debt…the tax shield provides wealth to the owners of the company (again cutting into the government’s share) and the WACC is falling across this range

  • At some point the costs of financial distress begin to enter as more debt is added

  • Eventually the additional $1 benefit of the tax shield is exactly offset by the additional cost of financial distress

  • At that point WACC is lowest and we have the optimal debt/equity ratio for the firm.

  • See Figure 16.6 on page 510


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