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Capital Structure

Chapter Outline

16.1 Capital Structure Choices

16.2 Capital Structure in Perfect Capital Markets

16.3 Debt and Taxes

16.4 Costs of Bankruptcy and Financial Distress

16.5 Optimal Capital Structure: The Tradeoff Theory

16.6 Additional Consequences of Leverage: Agency Costs and Information

Learning Objectives

Examine how capital structures vary across industries and companies

Understand why investment decisions, rather than financing decisions, fundamentally determine the value and cost of capital of the firm

Describe how leverage increases the risk of the firm’s equity

Demonstrate how debt can affect firm value through taxes and bankruptcy costs

Learning Objectives (cont’d)

Show how the optimal mix of debt and equity trades off the costs (including financial distress costs) and benefits (including the tax advantage) of debt

Analyze how debt can alter the incentives of managers to choose different projects and can be used as a signal to investors

Weigh the many costs and benefits to debt that a manager must balance when deciding how to finance the firm’s investments

16.1 Capital Structure Choices

When raising funds from outside investors, a firm must choose what type of security to issue and what capital structure to have.

16.1 Capital Structure Choices

Capital structure

The collection of securities a firm issues to raise capital from investors.

Firms consider whether the securities issued:

Will receive a fair price in the market

Have tax consequences

Entail transactions costs

Change future investment opportunities

16.1 Capital Structure Choices

A firm’s debt-to-value ratio is the fraction of the firm’s total value that corresponds to debt

D / (E+D)

16.2 Capital Structure in Perfect Capital Markets

A perfect capital market is a market in which:

Securities are fairly priced

No tax consequences or transactions costs

Investment cash flows are independent of financing choices

16.2 Capital Structure in Perfect Capital Markets

Unlevered equity

equity in a firm with no debt

Levered equity

equity in a firm that has debt outstanding

Leverage will increase the risk of the firm’s equity and raise its equity cost of capital

16.2 Capital Structure in Perfect Capital Markets

Modigliani and Miller (MM) with perfect capital markets

In an unlevered firm, cash flows to equity equal the free cash flows from the firm’s assets.

In a levered firm, the same cash flows are divided between debt and equity holders.

The total to all investors equals the free cash flows generated by the firm’s assets.

Figure 16.3 Unlevered Versus Levered Cash Flows with Perfect Capital Markets

16.2 Capital Structure in Perfect Capital Markets

MM Proposition I:

In a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is not affected by its choice of capital structure.

VL= E + D =VU (Eq. 16.1)

Table 16.1 Returns to Equity in Different Scenarios with and Without Leverage

Figure 16.4 Unlevered Versus Levered Returns with Perfect Capital Market

Example 16.1 The Risk and Return of Levered Equity

Problem:

Suppose you borrow only $6,000 when financing your coffee shop.

According to Modigliani and Miller, what should the value of the equity be? What is the expected return?

Example 16.1 The Risk and Return of Levered Equity

Solution:

Plan:

The value of the firm’s total cash flows does not change: it is still $30,000. Thus, if you borrow $6000, your firm’s equity will be worth $24,000. To determine its expected return, we will compute the cash flows to equity under the two scenarios . The cash flows to equity are the cash flows of the firm net of the cash flows to debt (repayment of principal plus interest).

Example 16.1 The Risk and Return of Levered Equity

Execute:

The firm will owe debt holders

$6,000 1.05 = $6,300 in one year.

Thus, the expected payoff to equity holders is

$34,500 – $6,300 = $28,200,

for a return of

$28,200 / $24,000 – 1 = 17.5%.

Example 16.1 The Risk and Return of Levered Equity

Evaluate:

While the total value of the firm is unchanged, the firm’s equity in this case is more risky than it would be without debt, but less risky than if the firm borrowed $15,000.

To illustrate, note that if demand is weak, the equity holders will receive $27,000 – $6,300 = $20,700, for a return of $20,700/$24,000 – 1 = – 13.75%.

Example 16.1 The Risk and Return of Levered Equity

Evaluate (cont’d):

Compare this return to – 10% without leverage and – 25% if the firm borrowed $15,000. As a result, the expected return of the levered equity is higher in this case than for unlevered equity (17.5% versus 15%), but not as high as in the previous example (17.5% versus 25% with more leverage).

Example 16.1a The Risk and Return of Levered Equity

Problem:

Suppose you borrow $50,000 when financing a coffee shop which is valued at $75,000. You expect to generate a cash flow of $75,000 at the end of the year if demand is weak, $84,000 if demand is as expected and $93,000 if demand is strong. Each scenario is equally likely. The current risk-free interest rate is 4%, and there’s an 8% risk premium for the risk of the assets.

According to Modigliani and Miller, what should the value of the equity be? What is the expected return?

Example 16.1a The Risk and Return of Levered Equity

Solution:

Plan:

The value of the firm’s total cash flows does not change: it is still $75,000 (expected cash flow of $84,000 discounted at 12%). Thus, if you borrow $50,000, your firm’s equity will be worth $25,000. To determine its expected return, we will compute the cash flows to equity under the two scenarios. The cash flows to equity are the cash flows of the firm net of the cash flows to debt (repayment of principal plus interest).

Example 16.1a The Risk and Return of Levered Equity

Execute:

The firm will owe debt holders

$50,000 1.04 = $52,000 in one year.

Thus, the expected payoff to equity holders is

$84,000 – $52,000 = $32,000,

for a return of

$32,000 / $25,000 – 1 = 28%.

Example 16.1a The Risk and Return of Levered Equity

Evaluate:

While the total value of the firm is unchanged, the firm’s equity in this case is more risky than it would be without debt.

To illustrate, if demand is weak, the equity holders will receive $75,000 – $52,000 = $23,000, for a return of $23,000/$25,000 – 1 = – 8%.

If demand is strong, the equity holders will receive $93,000 – $52,000 = $41,000, for a return of $41,000/$25,000 – 1 = 64%.

Without debt, equity holders expect to receive $84,000/75,000 – 1 = 12%.

Example 16.1b The Risk and Return of Levered Equity

Problem:

Suppose you borrow $25,000 when financing a coffee shop which is valued at $75,000. As in Example 16.1a, you expect to generate a cash flow of $75,000 at the end of the year if demand is weak, $84,000 if demand is as expected and $93,000 if demand is strong. Each scenario is equally likely. The current risk-free interest rate is 4%, and there’s an 8% risk premium for the risk of the assets.

According to Modigliani and Miller, what should the value of the equity be? What is the expected return?

Example 16.1b The Risk and Return of Levered Equity

Solution:

Plan:

The value of the firm’s total cash flows does not change: it is still $75,000 (the expected $84,000 cash flow discounted at 12%). Thus, if you borrow $25,000, your firm’s equity will be worth $50,000. To determine its expected return, we will compute the cash flows to equity under the two scenarios. The cash flows to equity are the cash flows of the firm net of the cash flows to debt (repayment of principal plus interest).

Example 16.1b The Risk and Return of Levered Equity

Execute:

The firm will owe debt holders

$25,000 1.04 = $26,000 in one year.

Thus, the expected payoff to equity holders is

$84,000 – $26,000 = $58,000,

for a return of

$58,000 / $50,000 – 1 = 16%.

Example 16.1b The Risk and Return of Levered Equity

Evaluate:

While the total value of the firm is unchanged, the firm’s equity in this case is more risky than it would be without debt, but less risky than if the firm borrowed $50,000.

To illustrate, if demand is weak, the equity holders will receive $75,000 – $26,000 = $49,000, for a return of $49,000/$50,000 – 1 = – 2%.

If demand is strong, the equity holders will receive $93,000 – $26,000 = $67,000, for a return of $67,000/$50,000 – 1 = 34%.

16.2 Capital Structure in Perfect Capital Markets

Homemade leverage

Investors use leverage in their own portfolios to adjust firm’s leverage

A perfect substitute for firm leverage in perfect capital markets.

16.2 Capital Structure in Perfect Capital Markets

Leverage and the Cost of Capital

Weighted average cost of capital (pretax)

(Eq. 16.2)

16.2 Capital Structure in Perfect Capital Markets

MM Proposition II: The cost of capital of levered equity:

The Cost of Levered Equity

Cost of levered equity equals the cost of unlevered equity plus a premium proportional to the debt-equity ratio.

(Eq. 16.3)

Example 16.2 Computing the Equity Cost of Capital

Problem:

Suppose you borrow only $6,000 when financing your coffee shop. According to MM Proposition II, what will your firm’s equity cost of capital be?

Example 16.2 Computing the Equity Cost of Capital

Solution:

Plan:

Because your firm’s assets have a market value of $30,000, by MM Proposition I the equity will have a market value of $24,000 = $30,000 – $6,000. We can use Eq. 16.3 to compute the cost of equity. We know the unlevered cost of equity is ru = 15%. We also know that rD is 5%.

Example 16.2 Computing the Equity Cost of Capital

Evaluate:

This result matches the expected return calculated in Example 16.1 where we also assumed debt of $6,000. The equity cost of capital should be the expected return of the equity holders.

Example 16.2a Computing the Equity Cost of Capital

Problem:

Referring back to Example 16.1a, suppose you borrow $50,000 when financing your coffee shop. According to MM Proposition II, what will your firm’s equity cost of capital be?

Example 16.2a Computing the Equity Cost of Capital

Solution:

Plan:

Because your firm’s assets have a market value of $75,000, by MM Proposition I the equity will have a market value of $25,000 = $75,000 – $50,000. We can use Eq. 16.3 to compute the cost of equity. We know the unlevered cost of equity is ru = 12%. We also know that rD is 4%.

Example 16.2a Computing the Equity Cost of Capital

Evaluate:

This result matches the expected return calculated in Example 16.1a where we also assumed debt of $50,000. The equity cost of capital should be the expected return of the equity holders.

Example 16.2b Computing the Equity Cost of Capital

Problem:

Referring back to Example 16.1b, suppose you borrow $25,000 when financing your coffee shop. According to MM Proposition II, what will your firm’s equity cost of capital be?

Example 16.2b Computing the Equity Cost of Capital

Solution:

Plan:

Because your firm’s assets have a market value of $75,000, by MM Proposition I the equity will have a market value of $50,000 = $75,000 – $25,000. We can use Eq. 16.3 to compute the cost of equity. We know the unlevered cost of equity is ru = 12%. We also know that rD is 4%.

Example 16.2b Computing the Equity Cost of Capital

Evaluate:

This result matches the expected return calculated in Example 16.1b where we also assumed debt of $25,000. The equity cost of capital should be the expected return of the equity holders.

16.3 Debt and Taxes

Market imperfections can create a role for the capital structure.

Corporate taxes:

Corporations can deduct interest expenses.

Reduces taxes paid

Increases amount available to pay investors.

Increases value of the corporation.

16.3 Debt and Taxes

Consider the impact of interest expenses on taxes paid by Safeway, Inc.

In 2008, Safeway had earnings before interest and taxes of $1.85 billion

Interest expenses of $400 million

Corporate tax rate is 35%

Compare Safeway’s actual net income with what it would have been without debt.

Table 16.2 Safeway’s Income with and without Leverage, 2008 ($ millions)

Total amount available to all investors is:

16.3 Debt and Taxes

Interest Tax Shield

The gain to investors from the tax deductibility of interest payments

Interest Tax Shield = Corporate Tax Rate Interest Payments

Example 16.3 Computing the Interest Tax Shield

Problem:

Shown on the next slide is the income statement for E.C. Builders (ECB). Given its marginal corporate tax rate of 35%, what is the amount of the interest tax shield for DFB in years 2007 through 2010?

Example 16.3 Computing the Interest Tax Shield

Solution:

Plan:

From Eq. 16.4, the interest tax shield is the tax rate of 35% multiplied by the interest payments in each year.

Example 16.3 Computing the Interest Tax Shield

Evaluate:

By using debt, ECB is able to reduce its taxable income and therefore decrease its total tax payments by $115.5 million over the four-year period. Thus the total amount of cash flows available to all investors (debt holders and equity holders) is $115.5 million higher over the four-year period.

Example 16.3a Computing the Interest Tax Shield

Problem:

Shown on the next slide is the income statement for Comanche Industries. Given its marginal corporate tax rate of 39%, what is the amount of the interest tax shield for Comanche in years 2007 through 2010?

Example 16.3a Computing the Interest Tax Shield

Solution:

Plan:

From Eq. 16.4, the interest tax shield is the tax rate of 39% multiplied by the interest payments in each year.

Example 16.3a Computing the Interest Tax Shield

Evaluate:

By using debt, Comanche is able to reduce its taxable income and therefore decreased its total tax payments by $48.0 million over the four-year period. Thus the total amount of cash flows available to all investors (debtholders and equity holders) is $48.0 million higher over the four-year period.

16.3 Debt and Taxes

When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.

To determine the benefit, compute the present value of the stream of future interest tax shields.

16.3 Debt and Taxes

By increasing the cash flows paid to debt holders through interest payments, a firm reduces the amount paid in taxes.

The increase in total cash flows paid to investors is the interest tax shield.

16.3 Debt and Taxes

Value of the Interest Tax Shield

Cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield.

By the Valuation Principle the same must be true for the present values of these cash flows.

16.3 Debt and Taxes

Value of the Interest Tax Shield

MM Proposition I with taxes:

The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt:

VL = VU + PV(Interest Tax Shield) (Eq. 16.5)

Example 16.4 Valuing the Interest Tax Shield

Problem:

Suppose ECB from Example 16.3 borrows $2 billion by issuing 10-year bonds. ECB’s cost of debt is 6%, so it will need to pay $120 million in interest each year for the next 10 years, and then repay the principal of $2 billion in year 10. ECB’s marginal tax rate will remain 35% throughout this period. By how much does the interest tax shield increase the value of ECB?

Example 16.4 Valuing the Interest Tax Shield

Solution:

Plan:

In this case, the interest tax shield lasts for 10 years, so we can value it as a 10-year annuity. Because the tax savings are as risky as the debt that creates them, we can discount them at ECB’s cost of debt: 6%.

Example 16.4 Valuing the Interest Tax Shield

Execute:

The interest tax shield each year is 35% $120 million = $42 million. Valued as a 10-year annuity with a discount rate of 0.06, we have:

Because only interest is tax deductible, the final repayment of principal in year 10 is not deductible, so it does not contribute to the tax shield.

Example 16.4 Valuing the Interest Tax Shield

Evaluate:

We know that in perfect capital markets, financing transactions have an NPV of zero—the interest and principal repayment have exactly a present value of the amount of the bonds: $2 billion. However, the interest tax deductibility makes this a positive-NPV transaction for the firm. Because the government effectively subsidizes the payment of interest, issuing these bonds has an NPV of $309 million.

Example 16.4a Valuing the Interest Tax Shield

Problem:

Suppose Comanche from Example 16.3a borrows $1 billion by issuing 5-year bonds. Comanche’s cost of debt is 8%, so it will need to pay $80 million in interest each year for the next 5 years, and then repay the principal of $1 billion in year 5. Comanche’s marginal tax rate will remain 39% throughout this period. By how much does the interest tax shield increase the value of Comanche?

Example 16.4a Valuing the Interest Tax Shield

Solution:

Plan:

In this case, the interest tax shield lasts for 5 years, so we can value it as a 5-year annuity. Because the tax savings are as risky as the debt that creates them, we can discount them at Comanche’s cost of debt: 8%.

Example 16.4a Valuing the Interest Tax Shield

Execute:

The interest tax shield each year is 39% $80 million = $31.2 million. Valued as a 5-year annuity at 8%, we have:

The final repayment of principal in year 5 is not deductible, so it does not contribute to the tax shield.

Example 16.4a Valuing the Interest Tax Shield

Evaluate:

We know that in perfect capital markets, financing transactions have an NPV of zero—the interest and principal repayment have exactly a present value of the amount of the bonds: $1 billion. However, the interest tax deductibility makes this a positive-NPV transaction for the firm. Because the government effectively subsidizes the payment of interest, issuing these bonds has an NPV of $124.6 million.

16.3 Debt and Taxes

Interest Tax Shield with Permanent Debt

The level of future interest payments varies due to:

changes in the amount of debt outstanding,

changes in the interest rate on that debt,

changes in the firm’s marginal tax rate, and

the risk that the firm may default and fail to make an interest payment.

16.3 Debt and Taxes

Weighted Average Cost of Capital with Taxes

Another way to incorporate the benefit of the firm’s future interest tax shield

Weighted Average Cost of Capital with Taxes

16.3 Debt and Taxes

The reduction in the WACC increases with the amount of debt financing.

The higher the firm’s leverage, the more the firm exploits the tax advantage of debt, and the lower its WACC.

16.4 The Costs of Bankruptcy and Financial Distress

If increasing debt increases the value of the firm, why not shift to 100% debt?

With more debt, there is a greater chance that the firm will default on its debt obligations.

A firm that has trouble meeting its debt obligations is in financial distress.

16.4 The Costs of Bankruptcy and Financial Distress

Direct Costs of Bankruptcy

Each country has a bankruptcy code designed to provide an orderly process for settling a firm’s debts.

However, the process is still complex, time-consuming, and costly.

Outside professionals are generally hired.

The creditors may also incur costs during the process. They often wait several years to receive payment.

16.4 The Costs of Bankruptcy and Financial Distress

Direct Costs of Bankruptcy

Average direct costs are 3% to 4% of the pre-bankruptcy market value of total assets.

Likely to be higher for firms with more complicated business operations and for firms with larger numbers of creditors.

16.4 The Costs of Bankruptcy and Financial Distress

Indirect Costs of Financial Distress

Difficult to measure accurately, and often much larger than the direct costs of bankruptcy.

Often occur because the firm may renege on both implicit and explicit commitments and contracts.

Estimated potential loss of 10% to 20% of value

Many indirect costs may be incurred even if the firm is not yet in financial distress, but simply faces a significant possibility that it may occur in the future.

16.4 The Costs of Bankruptcy and Financial Distress

Examples:

Loss of customers:

Customers may be unwilling to purchase products whose value depends on future support or service from the firm.

Loss of suppliers:

Suppliers may be unwilling to provide a firm with inventory if they fear they will not be paid

16.4 The Costs of Bankruptcy and Financial Distress

Examples:

Cost to employees:

Most firms offer their employees explicit long- term employment contracts.

During bankruptcy these contracts and commitments are often ignored and employees can be laid off

Fire Sales of Assets:

Companies in distress may be forced to sell assets quickly.

16.5 Optimal Capital Structure: The Tradeoff Theory

Tradeoff Theory:

Total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs:

(Eq. 16.10)

16.5 Optimal Capital Structure: The Tradeoff Theory

Key qualitative factors determine the present value of financial distress costs:

The probability of financial distress

Depends on the likelihood that a firm will default.

Increases with the amount of a firm’s liabilities (relative to its assets).

It increases with the volatility of a firm’s cash flows and asset values.

16.5 Optimal Capital Structure: The Tradeoff Theory

Key qualitative factors determine the present value of financial distress costs:

The magnitude of the direct and indirect costs related to financial distress that the firm will incur.

Depend on the relative importance of the sources of these costs and likely to vary by industry.

16.5 Optimal Capital Structure: The Tradeoff Theory

As debt increases, tax benefits of debt increase until interest expense exceeds EBIT.

Probability of default, and hence present value of financial distress costs, also increases.

The optimal level of debt, D*, occurs when these the value of the levered firm is maximized.

D* will be lower for firms with higher costs of financial distress.

Figure 16.8 Optimal Leverage with Taxes and Financial Distress Costs

16.5 Optimal Capital Structure: The Tradeoff Theory

Costs of financial distress reduce the value of the levered firm.

Amount of the reduction increases with probability of default, which increases with debt level.

16.5 Optimal Capital Structure: The Tradeoff Theory

Tradeoff Theory:

firms should increase their leverage until it reaches the maximizing level.

The tax savings that result from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.

With higher costs of financial distress, it is optimal for the firm to choose lower leverage.

16.5 Optimal Capital Structure: The Tradeoff Theory

The Tradeoff Theory helps to resolve two important facts about leverage:

The presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield.

Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries.

16.6 Additional Consequences of Leverage: Agency Costs and Information

Agency costs:

costs that arise when there are conflicts of interest between stakeholders.

Managerial Entrenchment:

managers often own shares of the firm, but usually own only a very small fraction of the outstanding shares.

Shareholders have the power to fire managers.

In practice, they rarely do so.

16.6 Additional Consequences of Leverage: Agency Costs and Information

Separation of ownership and control creates the possibility of management entrenchment

Managers may make decisions that:

Benefit themselves at investors’ expense,

Reduce their effort,

Spend excessively on perks

Engage in “empire building.”

16.6 Additional Consequences of Leverage: Agency Costs and Information

If these decisions have negative NPV for the firm, they are a form of agency cost.

Debt provides incentives for managers to run the firm efficiently:

Ownership may remain more concentrated, improving monitoring of management.

Since interest and principle payments are required, debt reduces the funds available at management’s discretion to use wastefully.

16.6 Additional Consequences of Leverage: Agency Costs and Information

Equity-Debt Holder Conflicts

A conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt.

most likely to occur when the risk of financial distress is high.

managers may take actions that benefit shareholders but harm creditors and lower the total value of the firm.

16.6 Additional Consequences of Leverage: Agency Costs and Information

Agency costs for a company in distress that will likely default:

Excessive risk-taking

A risky project could save the firm even if the expected outcome is so poor that it would normally be rejected.

Under-investment problem

Shareholders could decline new projects.

Management could distribute as much as possible to the shareholders before the bondholders take over.

Figure 16.9 Optimal Leverage with Taxes, Financial Distress, and Agency Costs

16.6 Additional Consequences of Leverage: Agency Costs and Information

As debt increases, firm value increases

Interest tax shield (TCD)

Improvements in managerial incentives.

If leverage is too high, firm value is reduced by

present value of financial distress costs

agency costs

The optimal level of debt, D*, balances these benefits and costs of leverage.

16.6 Additional Consequences of Leverage: Agency Costs and Information

Asymmetric information

Managers’ information about the firm and its future cash flows is likely to be superior to that of outside investors.

This may motivate managers to alter a firm’s capital structure.

16.6 Additional Consequences of Leverage: Agency Costs and Information

Leverage as a Credible Signal

Managers use leverage to convince investors that the firm will grow, even if they cannot provide verifiable details.

The use of leverage as a way to signal good information is known as the signaling theory of debt.

16.6 Additional Consequences of Leverage: Agency Costs and Information

Market Timing

Managers sell new shares when they believe the stock is overvalued, and rely on debt and retained earnings if they believe the stock is undervalued.

16.6 Additional Consequences of Leverage: Agency Costs and Information

Adverse Selection and the Pecking Order Hypothesis

Suppose managers issue equity when it is overpriced.

Knowing this, investors will discount the price they are willing to pay for the stock.

Managers do not want to sell equity at a discount so they may seek other forms of financing.

16.6 Additional Consequences of Leverage: Agency Costs and Information

The pecking order hypothesis states:

Managers have a preference to fund investment using retained earnings, followed by debt, and will only choose to issue equity as a last resort.

Example 16.5 The Pecking Order of Financing Alternatives

Problem:

Axon Industries needs to raise $9.5 million for a new investment project. If the firm issues one-year debt, it may have to pay an interest rate of 8%, although Axon’s managers believe that 6% would be a fair rate given the level of risk. However, if the firm issues equity, they believe the equity may be underpriced by 5%. What is the cost to current shareholders of financing the project out of retained earnings, debt, and equity?

Example 16.5 The Pecking Order of Financing Alternatives

Solution:

Plan:

We can evaluate the financing alternatives by comparing what the firm would have to pay to get the financing versus what its managers believe it should pay if the market had the same information they do.

Example 16.5 The Pecking Order of Financing Alternatives

Execute:

If the firm spends $9.5 million out of retained earnings, rather than paying that money out to shareholders as a dividend, the cost of financing the project is $9.5 million.

Using one-year debt costs the firm $9.5 (1.08) = $10.26 million in one year, which has a present value based on management’s view of the firm’s risk of $10.26 (1.06) = $9.68 million.

Example 16.5 The Pecking Order of Financing Alternatives

Execute (cont’d):

If equity is underpriced by 5%, then to raise $9.5 million the firm will need to issue shares that are actually worth $10 million.

(For example, if the firm’s shares are each worth $50, but it sells them for 0.95 $50 = $47.50 per share, it will need to sell $9.5 million $47.50/share = 200,000 shares. These shares have a true value of 200,000 shares $50/share = $10 million.)

Thus, the cost of financing the project with equity will be $10 million.

Example 16.5 The Pecking Order of Financing Alternatives

Evaluate:

Comparing the three options, retained earnings are the cheapest source of funds, followed by debt, and finally by equity. The ranking reflects the effect of differences in information between managers and investors that result in a lemons problem when they issue new securities, particularly when issuing new equity.

Example 16.5a The Pecking Order of Financing Alternatives

Problem:

Perspective Industries needs to raise $32 million for a new investment project. If the firm issues one-year debt, it may have to pay an interest rate of 5%, although Perspective’s managers believe that 4% would be a fair rate given the level of risk. However, if the firm issues equity, they believe the equity may be underpriced by 7%. What is the cost to current shareholders of financing the project out of retained earnings, debt, and equity?

Example 16.5a The Pecking Order of Financing Alternatives

Solution:

Plan:

We can evaluate the financing alternatives by comparing what the firm would have to pay to get the financing versus what its managers believe it should pay if the market had the same information they do.

Example 16.5a The Pecking Order of Financing Alternatives

Execute:

If the firm spends $32 million out of retained earnings, rather than paying that money out to shareholders as a dividend, the cost of financing the project is $32 million.

Using one-year debt costs the firm $32 (1.05) = $33.6 million in one year, which has a present value based on management’s view of the firm’s risk of $33.6 (1.04) = $32.31 million.

Example 16.5a The Pecking Order of Financing Alternatives

Execute (cont’d):

If equity is underpriced by 7%, then to raise $32 million the firm will need to issue shares that are actually worth $34.4 million.

(For example, if the firm’s shares are each worth $86.02, but it sells them for 0.93 $86.02 = $80 per share, it will need to sell $32 million $80/share = 400,000 shares. These shares have a true value of 400,000 shares $86.02/share = $34.4 million.)

Thus, the cost of financing the project with equity will be $34.4 million.

Example 16.5a The Pecking Order of Financing Alternatives

Evaluate:

Comparing the three options, retained earnings are the cheapest source of funds, followed by debt, and finally by equity. The ranking reflects the effect of differences in information between managers and investors that result in a lemons problem when they issue new securities, particularly when issuing new equity.

16.7 Capital Structure: Putting It All Together

Use the interest tax shield if your firm has consistent taxable income

Balance tax benefits of debt against costs of financial distress

Consider short-term debt for external financing when agency costs are significant.

Increase leverage to signal confidence in the firm’s ability to meet its debt obligations.

16.7 Capital Structure: Putting It All Together

Be mindful that investors are aware that you have an incentive to issue securities that you know are overpriced

Rely first on retained earnings, then debt, and finally equity

Do not change the firm’s capital structure unless it departs significantly from the optimal level.

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