Capital structure, Modigliani & Miller, use of debt, levrage (Chapter 14 & 15) Flashcards
Financing a company – capital structure
Any company needs money to make investments. It may be financed either by equity (stocks), debt (borrowed money) or a combination of these two. This combination equals a company’s capital structure.
The market value V of a company is
* V = D + E
Where D is the market value of debt, and E is the market value of equity.
In principle, stockholders can choose gearing somewhere between D/V = 0% and D/V = 99.9%.
Financial levrage/gearing
The term financial leverage or gearing is used to describe the degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt. If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.
We have seen how debt will affect our Weighted Average Cost of Capital (WACC).
Generally a higher debt ratio (higher leverage) reduces the average cost of capital, since the interest on debt is lower than the required return on equity. In addition interest is tax deductible.
Stockholder intrest
There are two important questions:
* Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value.
* What is the ratio of debt-to-equity that maximizes the shareholder’s value?
As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
Financial leverage and firm value
Does leverage increase firm value? Since a higher leverage increases the expected EPS, does it mean that the company value also increases in value? What if we account for risk?
No. According to Modigliani and Miller’s proposition I (MM I), the market value of any firm is independent of its capital structure. In other words: Financial managers (i.e. stockholders) should not worry about the financial leverage of the firm.
Comparing the value of a levered with an unlevered company:
MM prove their first proposition by using two strategies, showing us that there is no difference whether you as an investor
* buy 100 shares in the levered company, or
* Borrow money yourself and buy 200 shares in the unlevered company, where you finance 50% of the shares by borrowing money (consequently creating the same leverage as the proposed levered company.)
MM Proposition II (No Taxes)
MM Propositions I & II (with taxes)
Cost of financial distress
A company in financial distress and on the verge of bankruptcy typically faces:
Direct Costs
Legal and administrative costs
Indirect Costs
Impaired ability to conduct business (e.g., lost sales, compromised supply chain)
Agency Costs (from conflict of interest between stockholders and bondholders)
* Selfish Strategy 1: Incentive to take large risks (nothing to lose anyways)
* Selfish Strategy 2: Incentive toward underinvestment (the investment results would be retained by the bondholders anyway)
* Selfish Strategy 3: Milking the property (liquidating dividends)
Bondholders protect themselves accordingly (against bond devaluation), by raising the interest rate that they require on the bonds.
How can cost of debt be reduced?
Protective Covenants
* E.g. limit dividend payout, limit sale of assets, minimum working capital requirement, limit on further borrowing, etc.
* Bond covenants, even if they reduce flexibility, can increase the value of the firm.
Debt Consolidation:
* If we minimize the number of parties, contracting costs fall.
Tax effects and financial distress
Signaling
- The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost.
- Since there is a tax shield for debt, investors view debt as a signal of firm value.
- Firms with low anticipated profits will take on a low level of debt (smaller tax shield).
- Firms with high anticipated profits will take on a high level of debt (higher tax shield).
- A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.
- Managers signal information when they change leverage.
Shirking, Perquisites, and Bad Investments: A note on agency cost of equity
- An individual will work harder for a firm if he is one of the owners than if he is one of the “hired help.”
- While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity.
- The free cash flow hypothesis: We might expect to see more wasteful activity in a firm with a capacity to generate large cash flows than in one with a capacity to generate only small flows.
- The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities.
- The free cash flow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.
The Pecking Order Theory
Growth and the debt/equity ratio
We have seen earlier that a company with growth is more worth than a company without growth (all other things equal). Growth implies significant equity financing, even in a world with low bankruptcy costs. Thus, high-growth firms will have lower debt ratios than low-growth firms. Growth is an essential feature of the real world. As a result, 100% debt financing is sub-optimal.
How firms establish capital structure
No exact formula is available for evaluating the optimal debt-equity ratio.
Most corporations have low Debt-Asset ratios.
Changes in financial leverage affect firm value.
* Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes.
* Another interpretation is that firms signal good news when they lever up.
There are differences in capital structure across industries.
There is evidence that firms behave as if they had a target Debt-Equity ratio (at least the larger firms).
Research and development typically has less resale value than land; thus, most of its value disappears in financial distress. Therefore, firms with large investments in tangible assets are likely to have higher target debt-equity ratios than firms with large investments in R&D.
Factors in target D/E-ratio:
* Taxes
* Type of assets
* Uncertainty of operating income
* Peking order and financial slack
