Transcript Lecture 7 - TalkTalk Business

Lecture 5
Capital
structure I
• Specifics of different sources of longterm financing
– Common stock vs preferred stock vs debt
• The Modigliani and Miller model
• The Miller model
7.1
The Long-Term Financial Deficit (1999)
Uses of Cash Flow
(100%)
Sources of Cash Flow
(100%)
Capital
spending
80%
Internal cash
flow (retained
earnings plus
depreciation)
70%
Net
working
capital plus
other uses
20%
Internal
cash flow
Financial
deficit
Long-term
debt and
equity 30%
External
cash flow
7.2
Capital Structure
• Firms usually spend more than they generate
internally
– The deficit is financed by new sales of debt & equity
• Sources of long-term financing:
– Internal financing
• Retained earnings
– External financing
• Debt
• Preferred stock
• Common stock
7.3
Elements of the Capital Structure
• Mix of different classes of capital:
– Retained earnings vs debt & equity
•
•
•
•
•
Control rights vs cash flow rights
Maturity: refinancing risk vs reinvestment risk
Agency conflict
Asymmetric information and signaling
Important subtopics:
– Debt: bank credit vs bonds
– Payout policy: dividends vs share repurchase
– Costs of new issues
7.4
Common Stock
• Basic Shareholders’ Rights (may differ for dual classes):
– Control rights
– Residual claim on assets (after paying up liabilities)
– Limited liability
• Components of Shareholders’ Equity:
–
–
–
–
Common Stock Par Value
Capital Surplus (directly contributed equity in excess of the par value)
Retained Earnings (accumulated over time)
Treasury Stock at Cost
• Shares: Authorized vs Issued vs Outstanding
• Market vs Book vs Replacement Value
–
–
–
–
MV = price of the stock times the number of shares outstanding
BV = par value + capital surplus + accumulated retained earnings
RV = current cost of replacing the assets of the firm
At the time a firm purchases an asset, MV=BV=RV
7.5
The Right to Elect the Directors
• The most important control device
– Directors are elected each year at an annual meeting by a vote of the
holders of a majority of shares who are present and entitled to vote
• Straight voting
– Shareholders have as many votes as shares and each position on the
board has its own election
– A tendency to freeze out minority shareholders
• Cumulative voting
– Each shareholder may cast # shares multiplied by # directors to be
elected; these votes can be distributed over one or more candidates
– The effect is to permit minority participation
• Proxy voting (giving voting right to someone else)
– Proxy fight: outsiders try to win enough proxy votes to oust the mgt
• Some (e.g. merger) decisions require supermajority (e.g. 75%)
7.6
Dividends
• Unless a dividend is declared by the board of
directors, it is not a liability of the corporation
– A corporation cannot default on an undeclared dividend
• The payment of dividends by the corporation is not a
business expense
– Therefore, they are not tax-deductible
• Dividends received by individual shareholders are
considered ordinary income and are fully taxable
– Intra-corporate dividend exclusion: corporations are taxed
only on the 20% of the received dividends
7.7
Corporate Long-Term Debt
• Bondholders have a contractual claim against the
corporation, not an ownership interest
– Creditors have no voting power unless the debt is not paid,
– when they can legally claim the assets of the firm
• The corporation’s payment of interest on debt is
considered a cost of doing business..
– and is fully tax-deductible
• Corporations are very adept at creating hybrid
securities that look like equity but are called debt
– Obviously, the distinction is important at tax time
– A corporation that succeeds is creating a debt security that
is really equity obtains the tax benefits of debt while
eliminating its bankruptcy costs
7.8
The Bond Indenture
• Amount of issue, date of issue, maturity, currency, par value
• Coupon payments: frequency, floating vs fixed rate
• Orderly repayment of debt (to avoid the balloon payment):
– Amortization, by regular installments through a sinking fund
– With serial bonds
• Option features:
– Call provision (possibility to retire the entire issue before the maturity)
– Convertibility into stocks
• Security (attachment to the property): debenture/note vs bond
• Protective covenants:
– Restrictions on further indebtedness, max dividends, min working K
• Seniority: subordinated debt paid after senior debt
• Other determinants of the market price:
– Default risk (credit rating), domestic / foreign / Eurobond
7.9
Dual Nature of Preferred Stock
• Preference over common stock in cash rights:
– in the payments of dividends
– in the assets in case of bankruptcy
• No voting rights, unless no dividends 6 quarters in a row
• Is it really debt in disguise?
– Fixed dividend: usually, cumulative (carried forward if not paid)
– Stated liquidating value
• Call provision: can be converted to common shares
• Corporations get 80% tax exemption on dividends
– But not on debt interest
– Most preferred stock in the U.S. is held by corporate investors
• Firms issuing the preferred stock:
– Utilities, with low taxable income, avoiding the risk of bankruptcy
7.10
Patterns of Financing
• Firms usually spend more than they generate
internally
– The deficit is financed by new sales of debt and equity
• Internally generated cash flow dominates as a source
of financing, typically between 70 and 90%
• New sales of debt prevail over new equity issues
• Outside the US, firms rely more on external equity
• Debt ratios for U.S. non-financial firms have been
below 50% of total financing
7.11
Choice of the Capital Structure
• The value of a firm: sum of the value of the
firm’s debt and the firm’s equity: V = B + S
• Why should the stockholders care about
maximizing firm value?
• Since the payoff of the
debtholders is fixed (in case
of no default), changes in
capital structure benefit the
stockholders if and only if the
value of the firm increases.
S
B
Value of the Firm
7.12
Modigliani-Miller Model: Assumptions
• Perfect capital markets:
–
–
–
–
Perfect competition
Firms & investors can borrow/lend at the same rate
No frictions (transaction costs / taxes / bankruptcy costs)
Informational efficiency
• No need for signaling
– Managers are perfectly aligned with shareholders
• No agency costs
• Firms can be classified to homogeneous risk classes
– No CAPM at that time
• Perpetual cash flows, no growth
• The firm can issue risk-free debt
7.13
Homemade Leverage: An Example
EPS of Unlevered Firm
Earnings for 40 shares
Less interest on $800 (8%)
Net Profits
ROE (Net Profits / $1,200)
Recession Expected Expansion
$2.50
$5.00
$7.50
$100
$64
$36
3%
$200
$64
$136
11%
$300
$64
$236
20%
We are buying 40 shares of a $50 stock and borrow
$800. We get the same ROE as in the levered firm.
Our personal debt equity ratio: B  $800  2
S
$1,200
3
7.14
Homemade (Un)Leverage: An Example
EPS of Levered Firm
Earnings for 24 shares
Plus interest on $800 (8%)
Net Profits
ROE (Net Profits / $2,000)
Recession Expected Expansion
$1.50
$5.67
$9.83
$36
$64
$100
5%
$136
$64
$200
10%
$236
$64
$300
15%
Buying 24 shares of an otherwise identical levered firm
along with some of the firm’s debt gives us ROE of the
unlevered firm.
This is the fundamental insight of MM
7.15
The MM Propositions (No Taxes), 1958
• Prop. I: firm's value is not affected by leverage
VL = VU
• Prop. II: leverage increases the risk and return to
stockholders
rs = r0 + (B/S) (r0 - rB)
rB is the interest rate (cost of debt)
rs is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
MM II: Cost of Equity and WACC
Cost of capital: r (%)
7.16
r0
rS  r0 
rW ACC 
B
 (r0  rB )
SL
B
S
 rB 
 rS
BS
BS
rB
rB
Debt-to-equity Ratio B
S
7.17
The MM Propositions (with Corporate Taxes), 1963
• Prop. I: firm's value increases with leverage
VL = VU + TC B
• Prop. II: the increase in equity risk and return
is partly offset by the tax shield of debt
rS = r0 + (B/S)×(1-TC)×(r0 - rB)
rB is the interest rate (cost of debt)
rs is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
TC is the corporate tax rate
7.18
Derivation of MM (with Corporate Taxes)
• Each period, shareholders and bondholders receive
(EBIT - RBB)(1 - TC) + RBB = EBIT(1 - TC) + TCRBB
• PV of this stream of CFs discounted at r0 and rB is
S + B ≡ VL = VU + TC B
• Thus, VU = S + B(1-TC). Both sides yield equal CFs:
r0VU = rSS+rBB(1-TC) or r0(S+B(1-TC)) =rSS+rBB(1-TC)
• The cost of equity:
rs = r0 + (B/S) (1-TC) (r0 - rB)
• WACC:
rS S/(S+B) + (1 - TC) rB B/(S+B) = r0 [1 - TC B/(S+B)]
7.19
MM II: Cost of Equity and WACC
Cost of capital: r
(%)
rS  r0 
B
 (1  TC )  (r0  rB )
SL
r0
rW ACC 
B
SL
 rB  (1  TC ) 
 rS
BSL
B  SL
rB
Debt-to-equity
ratio (B/S)
7.20
Summary: MM Model
Does it matter how to cut the pizza into pieces?
• In a world of no taxes:
– The firm’s value is fully determined by investments
• Shareholders can achieve any pattern of payouts they
desire with homemade leverage
• In a world of taxes, but no bankruptcy costs:
– The firm’s value increases with leverage
• If you count the government as the stakeholder, value of
the firm stays the same!
– WACC differs from r0
• Both models give unrealistic predictions
7.21
The Miller Model: Impact of Personal Taxes
Miller (1977) shows that the value of a levered
firm can be expressed in terms of an
unlevered firm as:
 (1  TC )  (1  TS ) 
VL  VU  1 
B
1  TB


where
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate
7.22
Derivation of the Miller Model
Assume that each year the firm earns EBIT and pays
interest on debt with face value F:
Shareholde rs in a levered firm receive
( EBIT  rB F )  (1  TC )  (1  TS )
Bondholder s receive
rB F  (1  TB )
Thus, the total cash flow to all stakeholde rs is
( EBIT  rB F )  (1  TC )  (1  TS )  rB F  (1  TB )
This can be rewritten as
 (1  TC )  (1  TS ) 
EBIT  (1  TC )  (1  TS )  rB F  (1  TB )  1 

1

T

B

7.23
Derivation of the Miller Model
The total CF to all stakeholders in the levered firm is:
 (1  TC )  (1  TS ) 
EBIT  (1  TC )  (1  TS )  rB F  (1  TB )  1 

1

T

B

The first term is the cash
flow of an unlevered firm
after all taxes.
Its value = VU
The bond promises to pay
rBF×(1-TB) after taxes and is
worth B=F(1-TB). Thus, the value
of the second term is:
 (1  TC )  (1  TS ) 
B  1 

The value of the sum of these
1

T
B


two terms must be VL
 (1  TC )  (1  TS ) 
VL  VU  1 
B
1  TB


7.24
Firm Value with Corporate & Personal Taxes
 (1  TC )  (1  TS ) 
VL  VU  1 
B
1  TB


VL = VU+TCB when TS =TB
VU
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
VL =VU
when (1-TB) = (1-TC)×(1-TS)
VL < VU when (1-TB) < (1-TC)×(1-TS)
Debt (B)
7.25
Interpretation of the Miller Model
• Personal tax rates differ: TS < TB
– Effective tax rate on capital gains is lower (can be deferred)
– 80% of dividends received by corporations are tax-exempt
– Many types of investment funds pay no taxes
• Bond market equilibrium (assuming TS = 0):
– The supply of funds is fixed at rS = r0/(1-TC)
– The demand rises from r0 sufficient for tax-exempt
investors to r0/(1-TB,i) for investors in i's tax bracket
– In equilibrium, no tax advantage for leverage
• An equilibrium amount of corporate debt is
determined by relative corporate & personal tax rates
7.26
DeAngelo-Masulis Model, 1980
• The tax shield may be underutilized:
– Effects of tax shield substitutes (depreciation and
investment tax credit)
– Higher debt increases probability of negative earnings and
bankruptcy
• Modified bond market equilibrium:
– The supply of funds depends on the corporation-specific
tax rate: rS = r0/(1-TC,i)
• The higher the level of tax shield substitutes and the
cost of bankruptcy, the lower the leverage
7.27
Value of the Firm
(MM-Proposition I with Taxes and Bankruptcy)
MM-with corporate taxes only
Value of the Firm
MM-with corporate taxes and
bankruptcy costs
MM-no taxes
Optimal debt-equity ratio
Debt-Equity Ratio (B/S)