Capital Structure

1. Capital Structure Merrill Lynch Investment Banking Institute July 2008 Prof. Michael R. Roberts

2. Topic Overview How should we think about capital structure? A benchmark: the M&M irrelevance propositions When is capital structure relevant? Taxes Bankruptcy costs Agency costs (benefits) Asymmetric information

3. The Intuition Behind M&M Buy a house today for $100,000 and sell one year later Assume mortgage rate is 10% E.g., [145,000 � (50,000 + 5,000)]/50,000 - 1 = 80%

4. Questions Does the value of the house depend on the size of the mortgage? What does change with the size of the mortgage?

5. Financing InvestmentExample All equity firm considers a project (note this info.): Invest $800 today Payoff tomorrow: $1400 if strong economy w.p. 50% $900 if weak economy w.p. 50% Risk-Free Rate (Rf) = 5% Project Risk Premium (Rp-Rf) = 10%

6. All Equity FinancingExample (Cont.) Project NPV = Present value of future cash flows to project less initial investment How much equity can we raise? (Present value of future cash flows to equity holders) What are returns to shareholders (in both states and expectation)? What are the entrepreneur�s profits?

7. Debt and Equity FinancingExample (Cont.) Now suppose borrow $500, in addition to selling equity Note: Project Cash Flows > Debt Owed in each state ? debt is risk-free ? Rd = Rf = 5% Payoffs to Debt and Equity M&M I ? Value of firm is independent of capital structure in perfect capital markets ? E = 500 Cash flows of D and E sum to Project cash flows ? D and E must sum to value of firm (Law of One Price) M&M I says that V = D + E, regardless of what D and E are!

8. Effect of Leverage on Risk and ReturnExample (Cont.) Why isn�t the value of equity ? Levered equity carries a higher risk premium than unlevered equity ? rE?15% anymore Levered equity = higher risk = higher return (25%) This is not due to default risk! (Debt is risk-free) Project risk is the same 15%

9. M&M I: Synopsis In a �perfect capital market,� the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure Value of Firm (V) = Value of Debt (D) + Value of Equity (E) (No matter what D and E are!) Only thing that matters for value (size of the pie) is the PV of the cash flows�doesn�t matter how you divide them up (slice the pie)

10. The Cost of Capital Remember: M&M I implies Vl = E + D = Vu ( = Va) Return on a portfolio equals weighted average of returns to the securities in the portfolio so But this implies:

11. M&M IILeverage, Risk, and the Cost of Capital M&M Proposition II says: The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio With �perfect capital markets� WACC is constant function of leverage because as D/E changes, rE changes to compensate For really high leverage, rD will change as well (rD = rA in limit)

12. WACC & Leverage in Perfect Capital Markets

13. Leverage and EPS Fallacy: Leverage can increase stock prices via its affect on EPS Rationale: Leverage leads to higher earnings per share, which in turn lead to higher stock prices Error: Ignores the impact of leverage on risk Example: Levitron Industries (LVI) Currently: All equity with 10mil shares with $7.50/share Next year: EBIT = $10mil Considering: borrowing $15mil @ 8% and use proceeds to repurchase 2mil shares @ $7.50/share What are the consequences of this transaction assuming perfect capital markets?

14. Implications of Leverage for EPSExample (Cont.) Initial EPS: LVI�s earnings (EBIT) = LVI has no debt ? Perfect markets ? Initial EPS = EPS after debt issuance & share repurchase: Creates Annual Interest Payments = Earnings after interest = Share Repurchase: # of shares after repurchase = EPS after debt issue & repurchase = EPS went up! Looks good but are shareholders really better off?

15. Leverage and EPS: A Closer LookExample (Cont.) M&M tells us that there can be no benefit so something must give... Imagine that EBIT was only $4mil (instead of $10mil) Before debt issuance EPS = After debt issuance and share repurchase EPS = So, when earnings are low, leverage amplifies EPS fall just as leverage amplifies EPS climb with high earnings This �amplification� effect is just increased risk of earnings! The higher expected EPS is associated with higher risk (i.e., M&M I still holds)

16. Leverage and EPS: A Picture Average EPS is higher for levered firm Risk is higher (steeper line) for levered firm

17. Leverage and Stock PriceExample (Cont.) Assume: LVI�s EBIT is constant in the future (10mil) All earnings are paid out in dividends If we increase EPS, what will happen to the share price? Unlevered: Recall: Earnings = $10mil & Shares = 10mil ? EPS = $1 Dividends/Share (DPS) = Value the company as a perpetuity to get the WACC Recall: Price/Share = $7.50 = Market Cap =

18. Leverage and Stock Price (Cont.)Example (Cont.) Levered: Recall: Issue $15mil debt to repo $15mil of equity @ $7.50/shr ? buyback $15mil/$7.50/shr = 2mil shr ? 10mil � 2mil = 8mil shares remaining after buyback M&M I ? New Market Cap = ? New D/E ratio = M&M II: New rE = Earnings � Interest = New EPS = New Share Price = Intuition: EPS is higher but so is risk, so shareholders demand higher return rE

19. Equity Issuances and According to CFOs in the US, what is the most important consideration when issuing equity Dilution! Fallacy: Issuing equity will dilute existing shareholders� ownership Rationale: more shares mean the firm must be divided among a larger # of shares, thereby reducing the value of each individual share Error: Ignores the fact that cash raised by issuance increases the firm�s assets. Example: Jet Sky Airlines (JSA) Currently: No debt 500mil shares trading @ $16/shr ? Market cap = $8bil Considering: Expanding operations by buying $1bil new planes with new equity @ current price $16/share What are the implications for the stock price?

20. Effect of Equity Issuances on Stock Prices The firm issues 62.5mil new shares @ $16/share to get $1bil Firm grows by $1bil, which offsets increase in shares Any gain or loss from issuance comes from project NPV (i.e. what you do with the proceeds) Key assumption: Sell the shares at a fair price!

21. Capital Structure in Perfect Capital MarketsSumming it Up Conservation of Value Principle for Financial Markets With perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return). M&M I: V = E + D Value of the firm is just the sum of E & D, regardless of what they are M&M II: rE = rA + D/E(rA - rD) Leverage increases risk of equity (not value according to M&M I)

22. What are Perfect Capital Markets What are the assumptions behind M&M? That is, when are the M&M propositions true? no taxes, no bankruptcy costs, no agency costs/benefits, no information asymmetry, and no transaction costs What the !@#$% ? What�s the point of this? If financial policy is to matter, it must be that it mitigates (or takes advantage of) one or more of these frictions Devise financial strategies around minimizing (maximizing) the adverse (beneficial) effects of these frictions

23. Debt and Taxes Corporations pay taxes on their profits after interest payments are deducted ? interest expense reduces taxes Example: Safeway, Inc.: Safeway�s 2005 net income is lower with leverage than without and�

24. Debt and Taxes (Cont.) �equity is lower with leverage than without But, Safeway has greater value with leverage! What�s going on? With leverage, Safeway is worth an additional $140mil This difference is just the value of the interest tax shield

25. The Picture with Taxes In a �perfect capital market,� V = D + E Now, the government gets a slice! We can minimize that slice by shielding income with debt!

26. The WACC with and Without Corporate Taxes

27. Leverage Recapitalization RevisitedExample Midco Industries: Currently: 20mil shares outstanding @ $15/share Stable earnings 35% tax rate Plan: Borrow $100mil (on permanent basis) Use proceeds to repurchase shares What happens after the share repurchase?

28. Before Recap: VA = VU = E = After Recap: PV(interest tax shield) = tCD = VL = VU + tCD = E = VL � D = Investors get $100mil from repo and equity is worth $235mil ? $35mil gain with leverage Leverage Recapitalization Revisited Example (Cont.)

29. Assume Midco repurchases shares @ current price $15/share Repurchase $100mil � $15/share = 6.67mil shares After repurchase New # of shares outstanding = New share price after repo = Shareholders that keep their shares gain Total gain = Leverage Recapitalization Revisited Example (Cont.)

30. Leverage Recapitalization RevisitedA Problem Why would anyone tender their shares for $15 if they know that after the recap their shares will be worth $17.63? Alternatively, why don�t I buy shares @ $15 before the repo, and then sell after the repo @ $17.63 for an arbitrage profit? It is precisely this arbitrage activity that will drive up the price before the recap! The announcement of the recap will drive up the stock price to incorporate the PV (interest tax shield) ex ante So Midco�s equity will rise from $300mil to $335mil before the repo Price per share will increase to $335mil / 20mil = $16.75 Tax shield surplus will be split evenly between those who tender their shares and those who keep their shares Original shareholders capture all of the surplus: $1.75 x 20mil = $35mil

31. Financial Distress Costs Direct Costs Legal fees, court costs, opportunity cost of time Indirect Costs Stakeholder flight Supplier Distributer Customer Employees Creditor intervention (covenant violations) Asset fire sales Shareholders pay for these costs!

32. The Picture with Taxes and Financial Distress Costs Now, there is deadweight loss due to financial distress costs We can minimize that slice by taking on less debt but then government�s piece gets bigger ? tradeoff

33. Agency Costs Agency Costs are costs that arise when there are conflicts of interest between the firm�s stakeholders Different claimants have different incentives, which can lead firms to undertake actions that hurt one groups to benefit another Overinvestment and Asset Substitution Underinvestment and Debt Overhang Agency costs are another cost of increasing leverage, just like bankruptcy costs

34. Are Agency Costs Important? Think about some of the giant collapses of the last decade Enron Worldcom Adelphi Think about all the mechanisms and institutions developed to address incentive conflicts What do all debt contracts contain? (Hint: It begins with a �c��) SEC SOX Board of Directors Think about why you do anything�it must be in your interest in one way or another

35. Asymmetric InformationStock Returns Around Equity Issuances

36. Capital Structure and Asymmetric Information Asymmetric information refers to a situation where parties have different information E.g., Managers often have better information relative to investors regarding their firm Adverse selection refers to the idea that with asymmetric information, the average quality of assets in the market will differ from the average overall quality Investors know managers are selling overvalued equity Lemons principle: when seller has private information about the value of a good, buyers will discount the price they will pay because of adverse selection Investors discount the price they will pay for the equity Alternative: Use debt as a signal to investors Issuing debt suggests that the firm really will grow since I�ve pre-committed to pay back the debt

37. Summary If you want to add value to a firm with financial policy or strategy, then you have to be able to point to at least one of the following channels Reducing taxes Reducing bankruptcy costs Mitigating incentive conflicts Getting managers to behave Mitigating adverse selection costs Credibly conveying to the market that you are a good firm Much of financial innovation revolves around addressing these issues to create value for firms/investors MIPS Junk Debt CDOs Syndicated Loans

38. Asset Substitution or OverinvestmentBaxter Inc. Owes $1mil due at end of year Without a change in strategy, assets will be worth only $0.9mil ? Baxter will default if they take no action Baxter�s considering a new strategy: No upfront investment Success will increase firm�s assets to $1.3mil w.p. 50% Failure will decrease firm�s assets to $0.3mil w.p. 50% This is a negative NPV project since expected value of firm�s assets decline from $900mil to $800mil But, does this mean Baxter won�t undertake the investment?

39. Asset Substitution or OverinvestmentBaxter Inc. (Cont.) Note: Equityholders gain $150mil from investment (0 to $150mil) Debtholders lose $250mil from investment ($900mil to $650mil) Net gain (loss) in firm value of -$100mil = NPV of strategy = 0.5(1300-900) + 0.5(300-900) = -100mi Equity holders have incentive to �gamble� with debt holder�s money but debt holders will anticipate this and pay less ex ante

40. Debt Overhang and UnderinvestmentBaxter Inc. Owes $1mil at end of year but without a change in strategy, assets will be worth only $0.9mil ? default Considering alternative strategy: Requires initial investment of $0.1mil Generates risk-free return of 50% Clearly a positive NPV investment Problem (?): Baxter doesn�t have the cash on hand Can they raise the money in the equity market?

41. Debt Overhang and UnderinvestmentBaxter Inc. (Cont.)

42. Agency Costs and the Value of Leverage Leverage can encourage managers and shareholders to act in ways that reduce firm value. It appears that equity holders benefit at expense of debt holders. But, ultimately the shareholders bear these agency costs. When a firm adds leverage to its capital structure, the decision has two effects on the share price. The share price benefits from equity holders� ability to exploit debt holders in times of distress. But, debt holders recognize this possibility and pay less for the debt when it�s issued ? reduces amount firm can distribute to shareholders. Debt holders lose more than shareholders gain from these activities and the net effect is a reduction in the initial share price of the firm.

43. Agency Costs and the Amount of LeverageExample Scenario 1: Do nothing Firm will be worth $0.9mil ? E = $0.5mil; D = $0.4mil Scenario 2: Risky strategy Equity worth only $0.45mil under risky strategy, $0.5mil under existing so shareholders will reject it

44. Agency Costs and the Amount of Leverage Example (Cont.) Scenario 3: Conservative strategy Shareholders value increase by $0.15mil for a $0.1mil investment so they�re willing to invest in the project

45. Mitigating Agency Costs Shorter maturity debt can offset agency costs by limiting scope of expropriation Covenants can mitigate agency costs by forcing managers to commit not to expropriate debtholders

46. Agency Benefits of Leverage Managerial Entrenchment occurs from the separation of ownership and control in which managers make decisions to benefit themselves at the expense of investors Leverage can preserve ownership concentration and mitigate agency costs Issuing debt can maintain the original shareholders stake, while issuing equity can dilute original shareholders incentives because any agency costs are shared with others Leverage can mitigate empire building tendencies arising from incentives to run large firms (e.g., salary structure, perquisites) Leverage imposes discipline by pre-committing the cash flows and by creditor monitoring

47. Agency Costs and the Tradeoff Theory The value of the levered firm can now be shown to be

48. Aggregate Sources of Funding for Capital Expenditures, U.S. Corporations

49. Leverage and the Equity Cost of CapitalExample Levered equity has a return sensitivity that is 125% that of unlevered equity ? risk premium is 125% that of unlevered equity

50. Effect of Leverage on Risk and Return Example (Cont.) The returns to equity holders are very different with and without leverage. Unlevered equity has a return of either 40% or �10%, for an expected return of 15%. Levered equity has higher risk, with a return of either 75% or �25%, for an higher expected return of 25%. Levered equity has twice the systematic risk of unlevered equity ? has twice the risk premium

51. Homemade Leverage and ArbitrageExample Same assets ? same value ? unlevered firm is undervalued (or levered firms is overvalued) Buy low and sell high! Buy the equity of the unlevered firm on margin to replicate the levered equity cash flows Short sell the equity of the levered firm

52. Leveraged Recapitalization A leveraged recapitalization is when a firm borrows money to pay a (large) special dividend or repurchase (a lot of) shares Example: Harrison Industries All equity firm: 50mil shares @ $4/share ? Market Cap = $200mil Plan: Borrow $80mil to repurchase @ $4/shr, $80mil/$4 = 20mil shares What are the implications of the planned recap?

53. Leveraged Recapitalization Example (Cont.) Note: Share price doesn�t change since it�s a 0-NPV transaction: $80mil in debt for $80mil in equity

54. Multiple Securities When firms have multiple securities, the WACC is computed by a weighted average cost of capital of all the securities Example: Consider entrepreneur�s firm at outset but Capital structure is: Risk-free debt = 500 @ 5% Equity = 440 @ rE Warrants = 60: pay 210 in strong economy and 0 in weak The WACC is:

55. Multiple SecuritiesExample (Cont.) Compute return on Warrants, rW: Compute return on equity, rE: Compute WACC

56. Net Debt We can view cash as �negative debt� It�s risk-free and reduces risk, the opposite of debt $1 of cash in the firm will earn the risk-free rate $1 of debt in the firm will pay the risk-free rate Net Debt = Debt � Cash (and Risk-Free Securities)

57. Cash and Beta Example Cisco�s net debt = 0 - $16bil = -$16bil Implies total value = E + D = $110bil + (-$16bil) = $94bil What�s going on? Equity has capitalized $94bil in assets and $16bil in cash Business assets are risky (�A = 2.57), cash is not (�C = 0) So, equity is less risky than firms business assets because of the cash

58. Interest Tax Shields withTarget Debt-Equity Ratios When a firm adjusts its leverage to maintain a target debt-equity ratio, we can compute its value with leverage, VL, by discounting its free cash flow using the weighted average cost of capital. The value of the interest tax shield can be found by comparing the value of the levered firm, VL, to the unlevered value, VU, of the free cash flow discounted at the firm�s unlevered cost of capital, the pretax WACC.

59. Valuing the Interest Tax Shield with a Target Debt-Equity Ratio Example Compute unlevered value Step 1: Compute pre-tax WACC Step 2: Compute firm value as growing perpetuity

60. Valuing the Interest Tax Shield with a Target Debt-Equity Ratio Example (Cont.) Compute levered value Step 1: Compute post-tax WACC Step 2: Compute firm value as growing perpetuity Compute value of interest tax shield

61. Interest Tax Shield with Personal TaxesExample In 2005: t*=15% VU=$300mil VL = VU + t*D = 300 + 0.15(100) = $315mil With 20mil original shares outstanding, stock price would increase by $15mil / 20mil = $0.75/share