Transcript INTRODUCTION TO CORPORATE FINANCE SECOND EDITION Lawrence Booth & W. Sean Cleary Prepared by Ken Hartviksen & Jared Laneus.

INTRODUCTION TO
CORPORATE FINANCE
SECOND EDITION
Lawrence Booth & W. Sean Cleary
Prepared by Ken Hartviksen & Jared Laneus
Chapter 21
Capital Structure Decisions
21.1 Financial Leverage
21.2 Determining Capital Structure
21.3 The Modigliani and Miller (M&M) Irrelevance
Theorem
21.4 The Impact of Taxes
21.5 Financial Distress, Bankruptcy, and Agency Costs
21.6 Other Factors Affecting Capital Structure
21.7 Capital Structure in Practice
Booth/Cleary Introduction to Corporate Finance, Second Edition
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Learning Objectives
21.1 Explain how business and financial risk affect a firm’s ROE and EPS
and identify the financial break-even points.
21.2 Identify the factors that influence capital structure.
21.3 Explain how Modigliani and Miller (M&M) “proved” their
irrelevance conclusion that the use of debt does not change the
value of the firm.
21.4 Explain how the introduction of corporate taxes affects M&M’s
irrelevance result.
21.5 Describe how financial distress and bankruptcy costs lead to the
static trade-off theory of capital structure.
21.6 Explain how information asymmetries and agency problems lead
firms to follow a pecking-order approach to financing.
21.7 Describe other factors that can affect a firm’s capital structure in
practice.
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Financial Leverage
• Leverage is the increased volatility in operating income over time,
created by the use of fixed costs in lieu of variable costs; it magnifies
profits and losses
• There are two types: operating leverage and financial leverage
• Both types of leverage have the same effect on shareholders, but are
accomplished in very different ways, for very different purposes
strategically
• Operating leverage is the increased volatility in operating income
caused by fixed operating costs
• Managers make decisions affecting the cost structure of the firm and
decide to invest in assets that give rise to additional fixed costs with
the intent to reduce variable costs
• Operating leverage is commonly accomplished when a firm becomes
more capital intensive and less labour intensive
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Financial Leverage
• Advantages of operating leverage include:
• Magnification of profits to shareholders if the firm is profitable
• Operating efficiencies, such as faster production, fewer errors, higher
quality, etc., usually resulting in increased productivity
• Disadvantages of operating leverage include:
• Magnification of losses to shareholders if the firm loses money
• Higher break-even points
• High capital cost of equipment and illiquidity
• Financial leverage is the increased volatility in operating income caused
by the corporate use of sources of capital that carry fixed financial costs
• Financial leverage can be increased by selling bonds or preferred stock
(i.e., taking on financial obligations with fixed annual claims on cash
flow), and then using the proceeds from the debt to retire equity (as
long as lenders do not prohibit this through the bond indenture or the
loan agreement)
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Financial Leverage
• Advantages of financial leverage include:
• Magnification of profits to shareholders if the firm is profitable
• Lower cost of capital at low to moderate levels of financial leverage
because interest expense is tax-deductible
• Disadvantages of financial leverage include:
• Magnification of losses to shareholders if the firm loses money
• Higher break-even points
• At higher levels of financial leverage, the low after-tax cost of debt is offset
by other effects such as: potential bankruptcy costs and agency costs
• Shareholders bear the added risks associated with the use of leverage
• Therefore, the higher the use of leverage, either operating or financial,
the higher the risk to the shareholder
• Higher leverage therefore causes an increased cost of capital because
shareholders require higher returns to compensate for the extra risk
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Business Risk
• All firms experience variability in sales and costs over time
• Some firms operate in highly volatile industries that are sensitive to
the business cycle, while others operate in more stable industries
that are largely unaffected by the business cycle
• Business risk is the variability of a firm’s operating income caused by
operational risk and is measured as the standard deviation of
earnings before interest and taxes (EBIT)
Booth/Cleary Introduction to Corporate Finance, Second Edition
business risk
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Business Risk
• Lenders to a firm insulate themselves from risk by:
•
•
•
•
Lending money through a formal, legally binding contract
Demanding a fixed rate of return on the loaned funds
Demanding other promises that will protect their interests
Demanding a high priority of claim in the event of corporate dissolution
or bankruptcy
• Shareholders bear the risks associated with business risk and the
added risks associated with the use of leverage because they are
residual claimants of the firm
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Financial Leverage
• Return on equity is the return earned by equity holders on their
investment in a company, as shown in Equation 21-1:
( EBIT  RD B)(1  T )
ROE 
SE
• Return on investment is the return on all of the capital provided
investors, both shareholders’ equity and short and long term debt;
as shown in Equation 21-2:
ROI 
EBIT (1  T )
SE  B
• If a firm is financed only with equity, then ROE = ROI
• If a firm is financed with a mix of debt and equity, then ROE can be
smaller or larger than ROI as leverage magnifies both positive and
negative returns
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Financial Leverage
• Using Equations 21-2 and 21-2, we can derive Equation 21-3:
ROE  ROI  ( ROI  RD )(1  T )
B
SE
• Notice that ROI measures the return earned by a firm’s operations, but
it does not measure the impact of how a firm is financed
• Equation 21-3 can be re-arranged as Equation 21-4:
B
B

ROI  ROI  1 
 RD (1  T )

SE
 SE 
• Notice that the second term in Equation 21-4 is fixed, but the firm term
depends on the firm’s ROI
Booth/Cleary Introduction to Corporate Finance, Second Edition
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Financial Leverage
• Figure 21-1 graphs Equation 21-4: ROE as a function of ROI
• The intersection of the blue and orange lines is the indifference point,
where ROEs for financing strategies are equal
• The financial break-even point is the horizontal-axis intercepts for both
lines, or the points at which the firm’s ROE is zero
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Rules of Financial Leverage
• For value maximizing firms, the use of debt increases the expected ROE, so
shareholders expect to be better off by using debt financing rather than
equity financing
• Financing with debt increases the variability of the firm’s ROE, which
usually increases the risk to common shareholders
• Financing with debt increases the likelihood of the firm running into
financial distress and possibly even bankruptcy
• Wider variation in ROI means magnified ROE
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Investing Using Leverage
• Figure 21-2 shows the monthly returns from investing in the S&P/TSX
Composite Index using two different financing strategies: investing in the
index (all equity, red line), and investing in the index with 80% borrowed on
margin (blue line)
• The added volatility of gains and losses over time is evident, and the
principles of leverage apply to corporations as well as households
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Indifference Analysis
• Indifference analysis is a profit-planning technique used to forecast the
EPS-EBIT relationships under different financing scenarios, and is the point
where the EPS of two alternative financing strategies are equal
• Equation 21-5 shows the formula for EPS, given EBIT less interest on debt
after-tax. # is the number of common shares outstanding:
( EBIT  RD B)(1  T )
EPS 
#
• Equation 21-6 shows EBIT as a simple linear function of EBIT:
EBIT(1  T ) RD B(1  T )
EPS 

#
#
• Equation 21-6 is illustrated in Figure 21-3, a graph of the EPS-EBIT
relationship on the following slide
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Profit Planning Charts
• The slopes of the lines in Figure 21-3 are a function of the number of
common shares outstanding (i.e., the dilution of EPS), so the all-equity
(orange) line has a lower slope because every dollar of net income is
divided by more common shares
• The horizontal-axis intercept is greater for the debt-financing scenario
because the firm must cover its interest expense before earnings begin to
accrue to the benefit of shareholders
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Determining Capital Structure
• Table 21-4 shows the results of a
1990 survey of 119 US companies
• External sources of information
include: (#2) consultations with
advisors and (#5) examining other
firms in the same or similar
industries
• The three primary sources of
information are: (#4) the impact
on profits, (#3) risk considerations
and (#1) an analysis of cash flows
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Determining Capital Structure
• Ratio analysis is useful in capital structure analysis
• Helpful stock ratios, which use balance sheet information, include:
• Total debt to total assets
• Debt to equity
• Flow ratios, which use income statement information, can be
combined with balance sheet data to determine the ability of a firm to
service its debt
• Equation 21-7 shows the fixed burden coverage ratio, which is an
expanded interest coverage ratio that looks at a broader measure of
both income and any expenditures associated with debt:
EBITDA
Fixed Burden Coverage
I  (Pref Div  SF) /(1  T )
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Determining Capital Structure
• Equation 21-8 shows the cash flow to debt ratio, which is a direct
measure of the cash flow over a period that is available to cover a
firm’s stock of outstanding debt:
Cash Flow to Debt 
EBITDA
Debt
• Equation 21-9 shows Altman’s Z-score, which is a method of
predicting the bankruptcy of a firm using five variables:
Z  1.2 X 1  1.4 X 2  3.3X 3  0.6 X 4  0.999X 5
•
•
•
•
•
X1 = working capital divided by total assets
X2 = retained earnings divided by total assets
X3 = EBIT divided by total assets
X4 = market values of total equity divided by non-equity book liabilities
X5 = sales divided by total assets
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Determining Capital Structure
• Table 21-5 illustrates the
application of these
measures using
information from
Moody’s. IG represents
investment grade
companies which have at
least a BBB long-term
bond rating. Non-IG
represents companies
which do not have an
investment-grade rating.
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The Modigliani and Miller (M&M)
Irrelevance Theorem
• The Modigliani and Miller Irrelevance Theorem concludes, under
some simplifying assumptions, that the value of a firm should not be
affected by the manner in which it is financed
• That is: capital structure is irrelevant if certain assumptions hold
• These assumptions are:
• Markets are perfect, which means that there are no transaction costs or
information asymmetries
• There are no taxes
• There is no risk of a costly bankruptcy or associated financial distress
• Two firms in the same “risk class” can therefore have different levels of
debt and the earnings of these firms are perpetuities
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The M&M Irrelevance Theorem:
Arbitrage Argument
• Arbitrage is a powerful force in capital markets, because it ensures that
where two identical assets trade at different prices, market trades will
spot the opportunity to earn riskless profits and trade until the prices are
equivalent
• Traders sell the overvalued assets and buy the undervalued asset
• These trading activities cause the price of the overvalued asset to fall and
the price of the undervalued asset to rise until both assets are
equivalently priced
• Traders earn abnormal profits from these trades until the prices of the
two securities move into equilibrium
• Market participants who find levered investments trading for a greater
value can, therefore, undo the leverage and earn abnormal profits
• Arbitrage will therefore force assets with equal payoffs to trade for the
same price
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The M&M Irrelevance Theorem:
Firm Value
• Equation 21-10 shows that, where payoffs are identical for two different
assets (a levered firm and an unlevered firm ), both should be priced
equivalently: V  S  D  V
U
L
L
• The value of the levered firm VL is equal to the value of its debt plus the value
of its equity (SL + D), which also equals the value of the unlevered firm VU
• Therefore, debt cannot destroy value
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The M&M Irrelevance Theorem:
Homemade Leverage
• Homemade leverage is the creation of the same effect of a firm’s
financial leverage through the use of personal leverage
• Individual investors can buy an unlevered firm and use personal debt to
replicate corporate leverage, or buy a levered firm and undo its effects
• M&M made a modeling assumption to simplify the analysis that the
firm’s earnings represent a perpetuity, therefore we can show that the
value of a levered firm’s equity is given by Equation 21-11 and the cost
of equity capital by Equation 21-12:
EBIT  K D D
SL 
Ke
Booth/Cleary Introduction to Corporate Finance, Second Edition
EBIT  K D D
Ke 
SL
23
The M&M Irrelevance Theorem:
Firm Value
• Since the value of the firm is unchanged by leverage, we can define the
unlevered value by discounting the firm’s expected EBIT by its
unlevered cost of equity, as in Equation 21-13:
EBIT
VU 
 S L  D  VL
KU
• Equation 21-14 shows that if a firm has no debt, the equity investor
requires the cost of unlevered equity (KU)
• The unlevered cost of equity depends on the firm’s business risk
• As the firm increases the amount of debt it uses for financing, the
equity cost increases due to the financial leverage risk premium
D
K e  KU  ( KU  K D )
SL
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The M&M Irrelevance Theorem:
Cost of Capital
• Equation 21-15 shows that, in a world without taxes, the WACC (KU) is
simply the weighted average of the cost of debt and the cost of equity:
KU  K E
S
D
 KD
V
V
• Figure 21-4 illustrates M&M without corporate taxes where the cost of
equity rises to offset the lower cost of debt producing a WACC that
remains unchanged by the use of financial leverage
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The M&M Irrelevance Theorem:
Cost of Capital
• If WACC remains the same regardless of the financial strategy
used by the firm, VL = VU
• As the use of debt financing increases, the cost of equity rises
so that, even if EPS increases through the use of debt financing,
that benefit is offset by a higher discount rate
• From a shareholder wealth perspective, under the M&M
assumptions, financing strategy is irrelevant
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The Impact of Taxes
• If we introduce corporate taxes into the M&M model, the value of the
firm drops
• Equation 21-16 shows that the higher the tax rate, the lower the value
of the firm:
EBIT(1  T )
VU 
KU
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The Impact of Taxes
• Equation 21-17 gives the value of the levered firm as the value of a firm
without leverage plus the corporate tax shield from debt financing:
V:L  VU  DT
• The total claims of corporate taxes, debt holders and equity holders are
borne by the pre-tax cash flow produced by the firm
• If the firm uses more debt, and interest on that debt is tax-deductible,
this produces a greater tax shield, reducing the government share of
the value of the private enterprise so the WACC must decrease
• Equation 21-18 shows that both interest cost and the financial leverage
risk premium on the equity cost are reduced by (1 – T)
K e  KU  ( KU  K D )(1  T )
Booth/Cleary Introduction to Corporate Finance, Second Edition
D
SL
28
The Impact of Taxes
• Figure 21-6 shows that as the use of debt increases, WACC decreases
monotonously and so the value of the firm in a world with corporate
taxes should increase
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The Impact of Taxes
• Equation 21-19 gives the WACC equation adjusted for the taxdeductibility of interest expenses on debt:
S
D
WACC  K e  K D (1  T )
V
V
• Equation 21-20 uses beta to adjust for the systematic risk of a firm,
assuming 100% debt financing is optimal (a controversial assumption):
D
K e  RF  MRP  U 1  (1  T )
SL
• Equity cost without any debt is therefore the risk-free rate plus the
market risk premium plus multiplied by the unlevered beta coefficient
• Equation 21-20 can be used to unlever betas to obtain the cost of
unlevered equity
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Financial Distress, Bankruptcy and Agency
Costs
• Bankruptcy is a state of insolvency that occurs when a firm commits an
act of bankruptcy, such as non-payment of interest, and creditors
enforce their legal rights to recoup money, or when a firm voluntarily
declares bankruptcy in order to be protected while reorganizing to
become solvent again
• There are two acts under which firms can reorganize:
• The Companies Creditors Arrangements Act (CCAA) is used by larger, more
complex firms. It is flexible, allowing the firm to pursue agreements with
creditors and/or employees to raise new financing. A trustee is appointed
by the court and there is a stay-of-proceedings.
• The Bankruptcy Insolvency Act (BIA) is limited in scope to prevent creditors
from seizing assets. There are no provisions for DIP financing nor to
impose a settlement on all creditors
Booth/Cleary Introduction to Corporate Finance, Second Edition
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Financial Distress, Bankruptcy and Agency
Costs
• Figure 21-7 illustrates the value of a firm as a call option for
shareholders
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Financial Distress, Bankruptcy and Agency
Costs
• Direct costs of bankruptcy are incurred as a direct result of bankruptcy:
• Liquidation of assets
• Loss of tax losses (which are potential tax shield benefits)
• Legal and accounting costs
• Indirect costs of bankruptcy are financial distress costs, or losses to a
firm prior to the declaration of bankruptcy:
• Agency costs
• Increasing costs of doing business, including: creditors tightening trade
credit terms, lenders increasing risk premiums and monitoring, loss of key
staff and increases in recruitment and retention costs, and distracted
management focused on financing and not on the management of
business operations
• Potentially reduced sales revenue
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Financial Distress, Bankruptcy and Agency
Costs
• Figure 21-8 illustrates the rising value of distress costs with increasing
debt:
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Financial Distress, Bankruptcy and Agency
Costs
• Agency costs are important in the “real world”
• It is possible for shareholders to act in their own best interests, at the
expense of debt holders
• For example, when a firm is under financial distress:
• Shareholders can favor some creditors over others
• Assets may be dissipated to related, but solvent companies
• Moral hazard can result in asymmetric payoffs
• Being aware of these risks, lenders take action to protect their interests,
including:
•
•
•
•
Demanding moratoriums on additional debt
Increasing the rate on adjustable-rate debt
Demanding additional surveillance of financial performance
Taking the firm to court to enforce rights
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Financial Distress, Bankruptcy and Agency
Costs
• The static tradeoff model is illustrated by Figure 21-9:
Booth/Cleary Introduction to Corporate Finance, Second Edition
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Financial Distress, Bankruptcy and Agency
Costs
• In the static tradeoff model, the impact of bankruptcy and financial
distress costs on M&M with corporate taxes is:
• The cost of equity rises throughout as more debt is added
• The cost of debt rises at higher debt levels
• WACC falls initially, because the benefits of the tax-deductibility of
interest expense outweigh the marginal increases in component
costs
• But, at higher levels of debt, the tax advantage of debt is offset and
the value of the firm falls as WACC starts to rise
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Other Factors Affecting Capital Structure
• The static tradeoff model ignores two important issues:
1. Information asymmetry problems
2. Agency problems
• These factors are likely responsible for what Myers and Donaldson
call the pecking order
• The pecking order is the order in which firms generally prefer to
raise financing:
1. Start with internal cash flow or retained earnings
2. Add debt
3. Then lastly issue more common equity to raise new funds
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Other Factors Affecting Capital Structure
• Factors that favor corporate ability and willingness to issue debt
include:
• Profitability
• Unencumbered tangible assets to be used as collateral for
secured debt
• Stable business operations over time
• Corporate size
• Growth rate of the firm
• Capital market conditions
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Booth/Cleary Introduction to Corporate Finance, Second Edition
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Appendix 21A Personal Taxes and Capital
Structure
• Merton miller argued that firms should strive to minimize all taxes, both
corporate and personal, paid on corporate income
• By doing so, the firm maximizes total cash flows available to security
holders after corporate and personal taxes
• Equation 21-A1 shows the value of a levered firm accounting for
personal and corporate tax rates
 (1  TC )(1  TD ) 
VL  VU  D 1 

1

T
P


where:
• TC = corporate tax rate
• TP = individual’s personal tax rate on ordinary income (including interest
income)
• TD = individual’s tax rate on dividend income
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Appendix 21A Personal Taxes and Capital
Structure
If (1 – TP) = (1 – TC) (1 – TD), then VL = VU
• This is M&M’s irrelevance proposition and is referred to as an integrated
tax system which has historically be used in Western Europe where
individuals get a tax credit for corporate taxes paid on their behalf
• There are no tax advantages for firms if they use debt
If (1 – TP) < (1 – TC) (1 – TD), then VL < VU
• Firms lose value by issuing debt, so there is an incentive for individuals to
borrow money rather than firms
If (1 – TP) > (1 – TC) (1 – TD), then VL > VU
• Firms add value by issuing debt
• This is a partially integrated tax system and is the system we have in
Canada
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Appendix 21A Personal Taxes and Capital
Structure
If TP = TD, the personal tax rate on dividends equals the tax rate on
ordinary and interest income:
• We have a classic tax system in which all personal income is taxed at
the same rate which, historically, is the system in place in the United
States
• Here the corporate tax shield holds even with personal taxes, so the
value of a levered firm equals the value of an unlevered firm plus
the tax shield created by paying interest expenses
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