Financing Decisions

1. Financing Decisions

2. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Basic Problems How much should the firm invest. What specific assets should the firm invest in? The Investiment or Capital Budgetin decision How should the cash required for Investment be raised? The Financing Decision The Dividend Decision

3. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia The role of the financial manager Financial manager Capital markets (investors holding financial assets) Firms’ operations (real assets) Cash Cash (financial assets) Cash Cash Cash reinvested

4. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia

5. Somequestions… Shouldthefirmreinvestmost of itsearnings in thebusiness, orshoulditpaythemout as dividends? Ifthefirmneeds more money, shoulditissue stock orshoulditborrow? Shoulditborrow short-termorlong-term? Shoulditborrowbyissuing a normal bond or a convertible bond? ….

6. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia CAPITAL STRUCUTRE Is the mix of different securities; the Firm aims to find the optimal combination that maximizes its overall market value TYPES OF SECURITIES Debt- Equity

7. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia FINANCIAL POLICY AND F. DEC. Firm’s Capital Structure construction has to follow the general goal that is to maximize the value • Is Our Capital Structure optimal? • M&M: financing decisions do not matter • in perfect capital markets • - Financing decisions do matter • Is our financial policy correct? It could be different?

8. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia MAXIMIZE THE VALUE OF THE FIRM E EQUITY VALUE OF THE FIRM DEBT D V V = E + D = CAPITAL STRUCTURE

9. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia M&M Proposition I (Debt Policy doesn’t matter) When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

10. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia • M&M Proposition I (Debt Policy doesn’t matter) • Assumptions • - By issuing 1 security rather than , company diminishes investor choice. This does not reduce value if: • Investors do not need choice, OR • There are sufficient alternative securities • - Capital structure does not affect cash flows e.g... • No taxes • No bankruptcy costs • No effect on management incentives

11. M&M Proposition I (Debt Policy doesn’t matter) Assumptions • By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: • Investors do not need choice, OR • There are sufficient alternative securities • Capital structure does not affect cash flows e.g... • No taxes • No bankruptcy costs • No effect on management incentives

12. No Magic in Financial Leverage MM'S PROPOSITION I If capital markets are doing their job, firms cannot increase value by tinkering with capital structure. Firm value is determined by real assets Capital structure is irrelevant

13. M&M (Debt Policy Doesn’t Matter) • Example • All Equity Financed • 50% debt • All Equity Financed; debt replicated by investors

14. No Magic in Financial Leverage MM'S PROPOSITION I Value additivity: if we have two streams of cash flow, A and B, the present value of A+B is equal to the present value of A plus de present value of B

15. Implications of Proposition I (example)

16. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia RETURNS RATIOS R.O.E. = RETURN ON EQUITY (re) R.O.E. = Net income / Risk Capital (EQUITY) R.O.A. = RETURN ON ASSETS (ra) R.O.A. = Operating income / Market value of all securities

17. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia THE RELATION BETWEEN R.O.E. AND R.O.A.: FINANCIAL LEVERAGE MODEL

18. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia THE RELATION BETWEEN R.O.E. AND R.O.A.: FINANCIAL LEVERAGE MODEL re=ra+(D/E)+(ra-rd) M&M Proposition II: the expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E). The rate of increase depends on the spread between ROA and return on debt.

19. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia re Rates of return ra rd D/E Risk free debt Risky debt

20. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia M&M Proposition II • Bonds are almost risk-free at low debt levels • rD is independent of leverage • rE increases linearly with debt-equity ratios and the increase in expected return reflects increased risk • As firms borrow more, the risk of default rises • rD starts to increase • rE increases more slowly (because the holders of risky debt bear some of the firm’s business risk)

21. Leverage and Risk Leverage increases the risk of firm’s

22. Leverage and Returns

23. WACC • WACC is the traditional view of capital structure, risk and return.

24. WACC Expected Return .20=rE Equity .15=rA All assets .10=rD Debt Risk BD BA BE

25. WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC?

26. WACC r rE rE =WACC rD D V

27. WACC (traditional view) r rE WACC rD D V

28. WACC (M&M view) r rE WACC rD D V

29. Value Creation with the Optimal Capital Structure

30. Equity (Risk Capital, patient money) • Debt • Trade-off and Pecking Order Theory • The optimal Capital Structure

31. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia EQUITY OWNER’S EQUITY VENTURE CAPITAL FINANCIAL INSTRUMENTS: Common stock Preferred stock

32. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia DEBT - short or long term? - fixed rate or floating rate? - wich kind of warranty? BANK DEBT BOND FINANCIAL INSTRUMENTS

33. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia DEBT - short or long term? - fixed rate or floating rate? - wich kind of warranty? BANK DEBT BOND FINANCIAL INSTRUMENTS

34. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia CONVERTIBLE SECURITIES WARRANTS CONVERTIBLE BONDS

35. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Benefit and cost of debt t = tax shield i = interest rate FB = t x i x Debt Kd = i x (1 - t) Kd = cost of debt after-tax Financial distress costs

36. Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

37. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Trade-off Theory of Capital Structure Debt’ benefits 1 Tax savings major tax shield > benefit Debt’s Costs 1 financial distress major risk > cost

38. C.S. & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why?

39. Capital Structure D x rD x Tc rD PV of Tax Shield = (assume perpetuity) = D x Tc Example:

40. Capital Structure Firm Value = Value of All Equity Firm + PV Tax Shield Example

41. C.S. & Taxes (Personal & Corp) Relative Advantage Formula ( Debt vs Equity ) 1-TP (1-TPE) (1-TC) Advantage RAF > 1 Debt RAF < 1 Equity

42. C.S. & Taxes (Personal & Corp) • All Debt All Equity Income BTCP 1.00 1.00 less TC=.46 0.00 0.46 Income BTP 1.00 0.54 Taxes TP =.5 TPE=0 0.50 0.00 After Tax Income 0.50 0.54 Income BTCP 1.00 less TC=.46 0.00 Income BTP 1.00 Taxes TP =.5 TPE=0 0.50 After Tax Income 0.50

43. C.S. & Taxes (Personal & Corp) • All Debt All Equity Income BTCP 1.00 1.00 less TC=.34 0.00 0.34 Income BTP 1.00 0.66 Taxes TP =.28 TPE=.21 0.28 0.139 After Tax Income 0.72 0.521 Income BTCP 1.00 less TC=.34 0.00 Income BTP 1.00 Taxes TP =.28 TPE=.21 0.28 After Tax Income 0.72

44. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Costs of financial distress

45. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Costs of financial distress

46. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Bankruptcy • Corporate bankruptcies occur when stockholders exercise their right to default • That right is valuable: when a firm gets into trouble, limited liability allows stocksholders simply to walk away from it, leaving all its troubles to its creditors. • Former creditors become the new stockholders, old stockholders are left with nothing • Bankruptcy is a legal mechanism for allowing creditors to take over when the decline in the value of assets triggers a default: it is not the cause of the decline, but a consequence

47. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Bankruptcy • Bankruptcy costs • Come out of stockholders pockets • Creditors foresee costs and foresee that they will pay them if firm defaults: • Demand compensation in advance in the form of higher payoffs when the firm does not default • Higher interest rates • Reduces possible payoffs to stockholders and reduces the present value of firm’s shares

48. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Financial distress • Indirect bankruptcy costs • Difficulties of running a firm while it is going through bankruptcy • High costs: reluctance of creditors to force bankruptcy • Financial distress costs: • Financial distress is costly if conflicts of interest between shareholders and creditors; conflicts in the way of proper operating, investment and financing decisions • Stockholders are tempted to play games and forsake the objective of maximizing the market value of the firms

49. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Financial distress “games” • Risk shifting • Refusing to contribute to equity capital • Cash in and run • Playing for time • Bait and switch

50. E A Dipartimento di Economia Aziendale Department of Business Administration UNIVERSITA’ DEGLI STUDI DI TORINO Facoltà di Economia Financial distress “games” • Risk shifting • Book balance sheet • Assets: net working capital (20), fixed assets (80) • Liabilities: bonds outstanding (50), common stock (50) • Market balance sheet: • Assets: net working capital (20), fixed assets (10) • Liabilities: bonds outstanding (25), common stock (5)