Transcript Class 2 - University of Southern California

Module I: Investment Banking:
Capital Structure and Valuation
Week 2 – January 19, 2006
J. K. Dietrich - FBE 532 – Spring 2006
Introduction
 Cash
flows to investors and their risk determine
the value of claims on the firm
 When a firm issues both debt and equity, it agrees
to split the cash flows produced by its real assets
between shareholders and bondholders. The firm’s
mix of securities is known as its capital structure.
 Firm value depends on capital structure in a
fundamental way. This lecture reviews the theory
of capital structure and its links to valuation.
J. K. Dietrich - FBE 532 – Spring 2006
2
Distribution of Corporate Income
EBIT
EAC (Div + Retained Earnings)
I (Fixed Claims)
T (No Value to Investors)
J. K. Dietrich - FBE 532 – Spring 2006
Cash Flow Determination

Items From the Income Statement
–
–
–
–
–
Revenues (R)
Cash Expenses (W)
Non-Cash Expenses (Dep)
Capital Expenditures (Capex)
Cost of Goods Sold (CGS):
» Excludes depreciation
– Interest Expense (Int)
– Taxes (T)
J. K. Dietrich - FBE 532 – Spring 2006
Cash Flow Determination
 Other
–
–
–
–
Items
Tax Rate (t)
Repayment of Principal (P)
Changes in Net Working Capital (DNWC)
Permanent Debt (D)
J. K. Dietrich - FBE 532 – Spring 2006
Definition of Earnings Components
 Earnings
Before Interest & Taxes [EBIT]
R-(W+Dep+CGS)
 Earnings
Before Interest, Taxes,
Depreciation (and Amortization) =
EBITD(A) = EBIT+Dep+(Amort)
 Amortization is associated with allocation
of past financial investments over book
value (e.g. good will)
J. K. Dietrich - FBE 532 – Spring 2006
Definitions of Earnings Components
 Pre-Tax
Income
– [EBIT-Int]
 Tax
Bill [T]
– t(EBIT-Int)
 Net
Income
– NI =Pre-Tax Income - T
J. K. Dietrich - FBE 532 – Spring 2006
Cash Flow Definitions
 Levered
Cash Flow [to equity] {LCF or FTE}
Money that goes to stockholders account
[R-(W+Dep+CGS+Int)](1-t)+Dep-Capex-P-DNWC
 Unlevered
Cash Flow {UCF}
Cash flow that would occur if there was no debt
(1-t)EBIT+Dep-Capex -DNWC
J. K. Dietrich - FBE 532 – Spring 2006
Value and Leverage Strategy
Conservative Strategy
Aggressive Strategy
Debt
Debt
Equity
Equity
J. K. Dietrich - FBE 532 – Spring 2006
Empirical Facts
 Most
corporations set a target debt ratio.
 There are many similarities in capital
structure
– Across firms in the same industry
– Across industries in different countries
– These regularities suggest that there are some
fundamental determinants of capital structure
J. K. Dietrich - FBE 532 – Spring 2006
10
Summary M-M Theory & Issues
M-M
ISSUES
CAPITAL
(1) TAXES
STRUCTURE
IRRELEVANT (2) BANKRUPTCY
STATE
OF DEBATE
TRADEOFFS
(3) AGENCY
DIVIDENDS
IRRELEVANT
(4) EQUILIBRIUM
(1) INFORMATION
(2) TAXES
(3) MILLERSCHOLES
J. K. Dietrich - FBE 532 – Spring 2006
EVIDENCE
An Example
 Consider
the following data for a company
reviewing its capital structure.
–
–
–
–
–
–
Number of Shares
Price Per Share
Market Value of Shares
Market Value of Debt
Interest Rate
Tax Rate
J. K. Dietrich - FBE 532 – Spring 2006
100
$20
$2,000
$0
10%
0
12
Possible Outcomes:
 Depending
on the state of the economy,
EBIT may be as predicted, below average or
above average.
 If EBIT is $250, as predicted, earnings per
share are $250/100 = $2.50 and the return
on equity is $2.50/$20 = 0.125 or 12.5
percent.
J. K. Dietrich - FBE 532 – Spring 2006
EBIT-EPS Table
Recession
Predicted
Boom
EBIT ($)
100
250
300
EPS ($)
1.00
2.50
3.00
Return on Equity (%)
5
12.5
15
Based on the hypothetical EBITs, we can compute the
associated EPS. This gives rise to the EBIT-EPS table or
chart.
J. K. Dietrich - FBE 532 – Spring 2006
14
EBIT-EPS Chart
3.5
3
EPS
2.5
2
1.5
1
0.5
0
0
50
100
150
200
EBIT
J. K. Dietrich - FBE 532 – Spring 2006
250
300
350
Desirability of Leverage
 Suppose
the company repurchases $1,000
of equity at $20 each
 The purchase is financed by issuing consol
bonds.
 The new capital structure consists of 50
shares of stock and $1,000 of debt.
J. K. Dietrich - FBE 532 – Spring 2006
Hypothetical Outcomes:
Levered Firm
Recession
Predicted
Boom
EBIT ($)
100
250
300
Interest ($)
100
100
100
Equity Earnings ($)
0
150
200
EPS ($)
0
3
4
Return on Equity (%)
0
15
20
J. K. Dietrich - FBE 532 – Spring 2006
17
EBIT-EPS Chart
4.5
Levered Firm
4.0
3.5
Unlevered Firm
3.0
EPS
2.5
2.0
1.5
1.0
0.5
0.0
0
50
100
J. K. Dietrich - FBE 532 – Spring 2006
150
200
EBIT
250
300
350
The Home-made Leverage
 Consider
an alternative scenario now
 Suppose an investor were to borrow $20
and invest $40 in two (unlevered) shares of
the original all equity company.
 The net cost to the investor is $20.
J. K. Dietrich - FBE 532 – Spring 2006
Home Made Leverage
Recession
Predicted
Boom
Share Earnings ($)
2
5
6
Interest on $20 ($)
2
2
2
Net Earnings ($)
0
3
4
Return on $20 inv (%)
0
15
20
J. K. Dietrich - FBE 532 – Spring 2006
20
Home Made Leverage
 The
returns from this strategy are exactly the same
as buying 1 share of the levered firm. Therefore a
share in the levered firm must sell for $20 (= 2 x
20 - 20).
 Investors on their own can accomplish what the
company can do by adding debt, so leverage will
not create value. This leads to the famous
irrelevance proposition of Merton Miller and
Franco Modigliani.
J. K. Dietrich - FBE 532 – Spring 2006
21
Miller-Modigliani Theory
 The
Miller-Modigliani Proposition I:
With no taxes and perfect financial
markets, the value of any firm is
independent of its capital structure.
J. K. Dietrich - FBE 532 – Spring 2006
22
Miller-Modigliani Theory:
Value of the Firm
Firm Value
Leverage has no effect on firm value when
there are no taxes and markets are perfect
All Equity
Firm Value
Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
Miller-Modigliani Theory: WACC
With no taxes and perfect markets, the
weighted average cost of capital is constant
%
Cost of Equity
WACC
Cost of Debt
Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
Implications
 The
Miller-Modigliani theorem is a starting
point to examining capital structure effects
in the real world.
 If capital structure matters, it is because one
of the MM assumptions is violated.
 The first assumption to relax is the
assumption that there are no corporate
taxes.
J. K. Dietrich - FBE 532 – Spring 2006
25
Miller-Modigliani Theory and Taxes
 As
a simple example, consider two firms, U
and L.
 Firm U has no debt and firm L has issued
consol bonds worth $200 at the current
interest rate of 10 percent; otherwise the
firms are the same.
J. K. Dietrich - FBE 532 – Spring 2006
26
Levered and Unlevered Firms
Firm U
Firm L
Operating Income ($)
100
100
- Interest to Bondholders ($)
0
-20
= Pretax Income ($)
100
80
- Tax at 34% ($)
-34
-27.2
= Net Income to Stockholders ($)
66
52.8
Value of Equity ($)
660
528
Value of Debt ($)
0
200
Value of the Firm (Debt + Equity)
($)
660
728
J. K. Dietrich - FBE 532 – Spring 2006
27
Implications
 This
simple example shows that interest tax
deductibility increases the value of the firm
that is levered.
 The tax bill of L is $6.80 less than that of U
 In effect, the government is paying 34
percent of the interest expense of L. This
perpetual reduction in taxes is worth
$6.80/0.10 = $68.
J. K. Dietrich - FBE 532 – Spring 2006
Value of the Interest Tax Shield
 The
present value of the tax shield accounts
for the difference in firm value.
 If tC is the corporate tax rate and rD the debt
rate, then interest payments = rD.D and the
tax shield is tC.rD.D.
– How do we value the tax shields with risk? The
most common approach is that the risk of the
tax shields is the same as the interest payments
generating them.
J. K. Dietrich - FBE 532 – Spring 2006
29
A Convenient Formula
 For
perpetual debt, we have:
PV tax shield = (tC.rD.D)/rD = tC.D
which is independent of rD.
 The MM Theorem with corporate taxes
implies: VL = VU + tCD.
– The PV of tax shields is lowered if the firm
does not borrow permanently or if it may not be
able to use the tax shields in the future.
J. K. Dietrich - FBE 532 – Spring 2006
30
A Paradox
 The
Miller-Modigliani theorem implies
capital structure is irrelevant if there are no
taxes and capital markets are perfect.
– Relaxing the assumption of no corporate taxes
leads to the result that the company should take
on as much debt as it can.
– But an all debt company is owned by its
creditors. What stops a company from being
entirely debt financed?
J. K. Dietrich - FBE 532 – Spring 2006
Miller-Modigliani Theory with
Corporate Taxes
Firm Value
Value of a Levered Firm
Present value of
the tax shield
All Equity
Firm Value
Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
MM With Taxes: WACC
With taxes, the weighted average cost of
capital declines with higher leverage
%
Cost of Equity
WACC
Cost of Debt
Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
A Reconciliation
 What
offsets the tax advantages of debt
financing?
– Bankruptcy costs
» But empirical evidence seems to suggest these direct
costs are quite small
– Costs of financial distress
» These costs may be sufficiently large as debt
increases that there it offsets the tax shield.
J. K. Dietrich - FBE 532 – Spring 2006
34
MM with Taxes and COFD
Firm Value
Optimal Leverage Zone Balances Tax
Advantages of Debt Against the Costs of
Financial Distress
All Equity
Firm Value
Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
MM with Taxes and COFD: WACC
The weighted average cost of capital declines
with higher leverage and then rises
%
Cost of Equity
WACC
Cost of Debt
Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
Real-World Capital Structure
 Some
stylized facts fit well with the theory
– Firms with high taxes rely more on debt
– Firms with a high percentage of intangible
assets rely on equity
– Firms with uncertain operating income avoid
debt
J. K. Dietrich - FBE 532 – Spring 2006
Cost of Capital for All Equity Firm?
 Many
- including some executives - believe
it is zero because
– there is no direct cost to internal funds or from
equity capital issued some time ago
– no obligation to pay a dividend.
 This
reasoning is wrong.
J. K. Dietrich - FBE 532 – Spring 2006
Cost of Capital for All Equity Firm?
 It
is the opportunity cost of the equity that
matters.
 The cost of capital is simply the rate that
investors use discount the cash flows from
the firm. Investors will price the stock to
offer this expected return. If CAPM holds
we have :
k e  E  R~e   RF   e  E  R~M   RF 
J. K. Dietrich - FBE 532 – Spring 2006
Cost of Capital for All-Debt
Financed Projects
 Many
firms issue either debt or equity to
finance purchases of new assets and
projects. What is the cost of capital for a
project financed 100% with debt?
 It is not the after-tax debt rate. Why?
– You cannot 100% debt-finance all projects
– Debt capacity comes from existing assets - not
all the tax shield is attributable to the project
J. K. Dietrich - FBE 532 – Spring 2006
Review
 The
capital structure decision is a crucial
one for the firm and is fundamentally linked
to questions of valuation
 Firms trade-off the tax benefits of debt
financing against the costs of financial
distress
 Finding the right capital structure is difficult
in practice
J. K. Dietrich - FBE 532 – Spring 2006
41
Next Week – January 26
 Review
background readings on valuation
implications of mergers and acquisitions
 Read, analyze and prepare individual writeup for Continental Carriers Inc. case
 Form group and sign-up members and
schedule meetings needed for group do
necessary work and write-up for next case
 Hand in case write-ups (group and
individual) at the beginning of classes
J. K. Dietrich - FBE 532 – Spring 2006