Does Capital Structure affect value? • Empirical patterns • Across Industries • Across Firms • Across Years • Who has lower debt? • High intangible assets/specialized assets • High growth firms • High cash flow volatility • High information asymmetry • Industry leaders • Is capital structure managed? • If so much time is spent on capital structure then there must be some value to it (or managers/investors are irrational)
Debt and Equity Only? • Typically thought of and measured this way • Much more complex • Investment opportunities and strategy (needs) • Financing (sources) • Cash balance • Distribution: Dividend and repurchases • Debt capacity • Equity capacity • Existing debt and equity • Other financial policies: Financial Hedging, Cash Flow Volatility, Forms of Compensation
How does capital structure affect value? • To prove this we start in the “perfect world” • Based on the work of Miller and Modigliani • Shows that capital structure is irrelevant • Value is derived from market imperfections • Example: What if a firm is considering issuing debt and retiring equal amounts of equity?
Position #1: Buy 100 shares of the levered firm ($20*100=$2,000 Initial Investment) Position #2: Buy 200 shares of the unlevered firm and borrow $2000 (($20*200)-$2,000=$2,000 Initial investment).
Capital Structure is Irrelevant • Miller and Modigliani assume perfect capital markets • Proposition #1: The market value of any firm is independent of its capital structure.
Firm Value: Perfect Capital Markets 190 170 150 130 V(Unlevered) Value 110 90 70 50 0% 25% 50% 75% 100% D/E
Market Imperfections: Taxes • Taxes • US Tax Code: Deductibility of interest leads to lower cost of debt (Rd(1-t)) • Simple specification overvalues benefit • Ignores personal taxes which • Decreases investors debt return • Increases investors preference for equity • Capital gains: Defer and rate difference • Dividend: Some portion is deductible
Market Imperfections: Contracting Costs • In imperfect markets, alternative ways to contract optimal behavior are necessary • Costs of financial distress • Underinvestment (rejecting NPV>0 projects), direct, indirect costs, etc. • Benefits of debt • Monitoring function, manages free cash flow problem (Accepting NPV<0 projects), etc. • Contracting costs and taxes are primary motives for static trade off theory debt
Market Imperfections: Information Costs • With asymmetric information, leverage may reveal something about the existing firm • Market timing: Managers take advantage of superior information • Issue equity when it is overvalued • Issue debt when it is undervalued • Signaling: Managers use financing to signal future prospects of firms • Issue equity to signal good growth opportunities (preserve financial flexibility) • Issue debt when expected cash flows are strong and stable • Motivates Pecking Order Theory
Can we quantify the value of market imperfections? Debt adds value to the firm due to the interest deductibility (assume taxes only) Assume the simple case:
Firm Value: Perfect Capital Markets 190 170 150 130 V(Unlevered) Value V(Levered) 110 90 70 50 0% 25% 50% 75% 100% D/E
More Complex Tax Shields • Uneven and/or limited time payments • Discount all flows back to time 0 • What r do you use? • Certain the tax shield can be used: rD • Uncertain? Higher r
Financial Distress • As leverage increases, the probability therefore PV of financial distress increases • How do we estimate the cost of distress? • Prob(Distress)*Cost of Distress • Probability can be estimated in several ways • Logit/Probit regressions • Debt ratings
Firm Value: with Taxes and Fiancial Distress 190 170 150 130 V(Unlevered) V(Levered) V(Distress) 110 90 70 50 D/E D/E
Financial Distress: Bankruptcy Costs • Direct Costs • Legal, accounting and other professional fees • Re-organization losses • Estimated btw 4-10% of firm value (t-3) • Indirect Costs • Reputation costs • Market share • Operating losses • Estimated as 7.8% of firm value (t-2)
Financial Distress: Agency Costs • Risk shifting and asset substitution • Shareholders invest in high risk projects and shift risk to the debt holders • Shareholders issue more debt, diminishing old debt holders protection • Underinvestment • Expropriating funds • Difficult to estimate
Other Advantages of Debt • Agency cost of Equity (motive) • Shirking is less likely when issuing debt • Perquisites are less likely with debt • Over-investment is less likely with debt • Agency cost of Free Cash Flow (opportunity) • Retained earnings versus dividends? • Growth and investment opportunities • Debt serves as a monitoring device, decreasing managerial discretion • Bankruptcy as a strategic move???
Formal Models of Capital Structure • Pecking Order • Firms prefer to raise capital • Internally generated funds • Debt • Equity • Implies capital structure is derived from • Financing needs and capital availability • Dynamic rather than static • Asymmetric information and signaling • Static Trade Off
Static trade-off theory of debt Firm Value Maximum Firm Value ActualFirmValue Debt Optimal amount of Debt
Implications of Static Trade Off • Static rather than dynamic • Taxes and Contracting Cost drive value • Readjustment may be sticky • Optimal trade off between cost of issuances and benefit of capital structure • Insights • Large, stable profit firms will have more debt • Higher the costs of distress lower debt • Lower taxes, lower debt • Less (more) favorable tax treatment of debt (equity), lower debt
Evidence: Taxes • This method usually overestimates the tax consequence • Magnitude of leverage differences across countries and tax regimes is not that big • Equity taxes (personal taxes) are overestimated (Miller) • Timing of capital gains • Higher effective marginal tax rate, higher the leverage (Graham, 2001)
Evidence • Contracting Costs: Consistent evidence • Higher (lower) the growth opportunities, higher (lower) the potential underinvestment problem, lower (higher) the leverage • Higher growth opportunities would prefer • Shorter maturity debt (or call provisions) • Less restrictive covenants • More convertibility provisions • More concentrated investors (private) • Information costs • Consistent with market timing (SEO’s lead to -3% return) • Inconsistent with signaling and pecking order • Taxes: Higher effective marginal tax rate, higher the leverage
MM: Proposition II • How does leverage affect rE • Start with the WACC • Solve for rE • The rate of return on the equity of a firm increases in proportion to the debt to equity ratio (D/E).
Blue Inc. has no debt and is expected to generate $4 million in EBIT in perpetuity. Tc=30%. All after-tax earnings are paid as dividends.The firm is considering a restructuring, with a perpetual fixed $10 million in floating rate debt at an expected interest rate of 8%. The unlevered cost of equity is 18%. • What is the current value of Blue? • What will the new value be after the restructuring? • What will the new required return on equity be? • What if we use the new WACC?
What About Financial Flexibility? • The ability to quickly change the level and type of financing • Value increasing if • Growth opportunities exist • Company is willing to exercise and extinguish future flexibility • New investments are unpredictable and large • Precautionary debt ratings cushion is valuable • Value destroying if the opposite is true
What do we do? • Choosing a target capital structure • Minimize taxes and contracting costs (while paying attention to information costs) • Target ratio should reflect the company’s • Expected investment requirements • Level and stability of cash flows • Tax status • Expected cost of financial distress • Value of financial flexibility • Dynamic management • Financing is typically a lumpy process • Find optimal point where cost of adjusting capital structure is equal to cost of deviating from target