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Chapter 16

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Chapter 16

Capital Structure

- 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

- 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

- What makes a good source of funds when we borrow?
- Is there an optimal borrowing strategy?
- Reduce overall costs with a different borrowing pattern

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 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

- 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 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 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

- 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

- 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

- 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 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 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

- 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

- M&M Proposition 1 – Capital Structure is irrelevant

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 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

- M&M Proposition 1 – with taxes

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

- 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

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

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