LT (4-6) Capital Structure

Question 1

What is Capital Structure?

Answer 1

Capital Structure refers to the mix of financing instruments (e.g. shares, preferred stock, bonds, warrants, etc.) a firm uses to fund its investments (assets).

Broadly speaking, we can think of capital structure as being composed of debt and equity.
Leverage ratio = Debt/Assets = Debt/(Debt + Equity)

Modigliani and Miller – six assumptions lead to Capital Structure Irrelevance
Firm value and shareholder wealth are independent of capital structure in perfect capital markets

Question 2

What is equity?

Answer 2

Equity:

Equity/Stock/Share-holders are owners of firm & have voting rights

Equity holders receive (random) dividends & can sell shares in stock market

Shareholders are protected by limited liability

Question 3

What is debt?

Answer 3

Many types: loans, bonds, notes

Bonds are long-term securitised loans, i.e. can be re-sold

Creditors/Debt-holders typically receive interest payments (fixed rates or floating rates), and repayment of principal at maturity

Interest payments are paid out of pre-tax profits

Question 4

What is the effect of increasing leverage for a company?

Answer 4

Leverage (more debt):

Boosts expected EPS and the expected return to equity, as long as the cost of debt (i.e. the interest rate) is lower than the firm’s expected return on invested capital (i.e. return on assets),

BUT

Also increases the risk of equity (even when the debt is risk-free!)

Question 5

What are the six assumptions of MM’s world of perfect capital markets?

Answer 5

Modigliani and Miller (1958) showed that under the following assumptions (‘perfect capital markets’):

1 Investment is held constant
2 No transactions costs
3 Efficient capital markets
4 Managers maximise shareholders’ wealth
5 No taxes (or, no differential tax treatment between equity and debt holders)
6 No bankruptcy costs (new one)

The value of the firm and the wealth of the shareholders do not change when you change capital structure

Question 6

Why is capital structure irrelavent in a MM world?

Answer 6

MM demonstrated that:

When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow.

→ Shareholders can borrow (and make their returns riskier) on their own (’homemade leverage’), so will not pay more to invest in an otherwise identical levered firm.

→ the market value of a company does not depend on its capital structure

Question 7

Summarise MM Proposition I.

Answer 7

If capital markets are doing their job, firms cannot increase value by changing their capital structure
Firm value is independent of the debt ratio
Capital structure is irrelevant, even if that debt is risky

Value of levered firm = Value of unlevered firm

where the market value of the firms assets are the same

MM Proposition I states that:

A = VU = VL = DL + EL
where:
A = market value of the firm’s assets
VU = market value of equity if firm is unlevered
VL = market value of firm if levered
DL = market value of debt if firm is levered
EL = market value of equity if firm is levered

Therefore, we can think of firm’s assets as a portfolio of the debt and equity securities used to fund them.

Question 8

What is the weighted average cost of capital formula?

Answer 8

We know that the expected return on a portfolio is a weighted average of the expected returns of its components, so that:
rA =wD ×rD +wE ×rE
And since portfolio weights are the proportion of the total market value of a portfolio that is invested in each security, we have:

rA= (D/D+E)×rD+ (E/D+E) ×rE
This is known as the weighted average cost of capital (WACC)

Re-arranging the WACC expression to make the expected return on levered equity, rE , the subject of the formula, we get:

rE =rA+D/E(rA−rD)

Question 9

What is MM proposition II?

Answer 9

MM Proposition II: The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E).

Any increase in expected return is exactly offset by an increase in risk.

This is why leverage does not affect value

rE =rA+D/E(rA−rD)

If the CAPM is true, then these changes in expected return produced by leverage should correspond to changes in CAPM betas.

βA = βD× (D/D+E) +βE× (E/D+E)

Rearranging

βE = βA+ (D/E) (βA−βD)

Question 10

Does debt policy matter in a MM world?

Answer 10

Summary of MM Propositions I and II

Financial leverage does not affect:
Risk or expected return on the firm’s assets
Firm value

Financial leverage does affect:
Risk and expected return on the firm’s common stock

Financial leverage may affect:
The risk or expected return on debt, depending on the amount of leverage and the nature of the default.

One or more of these assumptions (MM assumptions) must be false for Capital Structure choice to add value.

Question 11

What is the formula for the Interest Tax Shield? (Droping MM no taxes assumption.)

Answer 11

Interest Tax Shield = (D × rD ) × τc

First part is interest payment

Drop no taxes assumption from MM.

Question 12

What is the formula for after tax WACC

Answer 12

WACCAfter-Tax =rD ×(1−τc)× (D/V) +rE × (E/V)

Where V(alue) = E(quity) + D(ebt)

Question 13

When to use the after tax WACC?

Answer 13

If taxes are the only deviation from MM AND
the firm continuously rebalances its leverage to a target ratio, D/V
then
→ Discount FCF using the after-tax WACC

The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets.

Question 14

IF either assumption of after tax-wacc is violated (ie taxes are the only deviation from MM and the firm continually rebalances its leverage to a target ratio D/V) what should you use?

Answer 14

The Adjusted Present Value (APV) method does not capture taxes or other financing effects in a WACC tax-adjusted discount rate
Instead, it captures financing effects through additional present value calculations.
The APV approach:

APV = base case NPV + sum of PVs of financing side effects
Each term explicitly measures how a particular financing factor adds or subtracts value (benefits and costs from leverage.)

Financing side effects: Interest tax shield (+)
PV(future stream of tax savings from interest) Issue costs of securities (−)
Subsidies by a supplier or government (+)

The APV method can be used to incorporate other benefits and costs arising from leverage when we relax more MM assumptions, for example. .. costs arising from fiancial distress. (Bankruptcy costs (-)

Question 15

How do costs of financial distress occur?

Answer 15

Costs arising from bankruptcy or distorted business decisions before bankruptcy
Direct e.g. legal and accounting fees
Indirect e.g. losses from customers/suppliers abandoning firm
APV = base case NPV + sum of PVs of financing side effects − PV of costs of financial distress
Trade-off theory: Capital structure is based on a trade-off between tax savings and distress costs of debt

Question 16

What is the trade-off between leverage?

Answer 16

Trade-off theory: Capital structure is based on a trade-off between tax savings and distress costs of debt

Question 17

Who benefits from the Interest Tax Shield, shareholders or debt holders in perfect capital markets except for no taxes assumption dropped?

Answer 17

Because the ITS reduces the firm’s effective cost of debt, we can incorporate the benefit it brings to firm and shareholder value into the firm’s cost of capital. We define the firm’s after-tax cost of capital, its after-tax WACC, as:

WACCAT=rD(1−τc)(D/V) +rE (E/V)

WACCAT= WACCBT − rDτc(D/V)

so an increase in debt = reduction in firms cost of capital

(Financing does increase firm value (Accout for it sperately from FCF’s.)

Tax saving from debt, Holding FCF’s fixed —> the smaller the discount rate the higher the NPV. Under this world firms should be 100% debt financed.

Shareholders capture the benefit of the tax shield
(assuming securities are fairly priced)

Question 18

What is the Adjusted Present value formula for a levered firm with taxes?

Answer 18

(CF to investors levered) = (Cf to investors unlevered) + ITS (Interest tax shield.)

Value of levered firm = Value of unlevered firm + PV(interest tax shield)

PV (Interest tax shield) = [D x rD x τc] / rD
= D x τc (equivalent to a perputual bond)

Question 19

MM and taxes, why do firms not borrow more?

Answer 19

You can only use interest tax shields if there will be future profits to shield

Interest expense is not the only tax shield
Consider Investor/Personal taxes (Dropping no taxes MM assumption)
- Taxation at the personal level can potentially reduce the tax advantage of debt found at the corporate level.

Consider bankruptcy costs (Dropping no bankruptcy costs MM assumption.)

Question 20

What are coporate taxes?

Answer 20

Corporate taxes (τc) paid on profit of the firm

Question 21

What are personal taxes on equity income?

Answer 21

Shareholders have to pay personal taxes on equity income (τpE ):

The dividends that they receive from the firm

Capital gains from the increase in market value of the firm.

Question 22

What are personal taxes debt income?

Answer 22

Although interest is not taxed at the corporate level, debt investors are taxed on their interest income, sometimes as ordinary income (τp), which usually differs from τpE.

Question 23

What is the relative adavantadge of debt formula? (Relavent after dropping no taxes MM assumption)

Answer 23

We can measure the Relative Advantage of Debt (RAD) after all personal and corporate taxes have been deducted by comparing the after-tax amount that would be received by bondholders for each after-tax dollar received by stockholders:

RAD = 1 − τp / (1−τpE)(1−τc) = after tax amount recieved by bondholders/ after tax amount recieved by equity holders

If RAD > 1 → issue debt
If RAD < 1 → issue equity

Question 24

What is financial distress and bankruptcy?

Answer 24

The firm is in financial distress:
Market value of assets < face value of debt

A firm is in financial distress when it is experiencing difficulty meeting its debt obligations (i.e. interest and/or principal).

If the firm fails to make debt payments, it is in default or bankrupt or insolvent.

Bankruptcy/Insolvency is the legal process by which control of a bankrupt firm’s assets is handed over to its creditors.

Question 25

What are the costs arising from finacial distress? (CFD)

Answer 25

Costs of Financial Distress (CFD) are costs arising from bankruptcy or distorted business decisions before bankruptcy
Direct – legal and administrative costs of bankruptcy Indirect – losses from customers/suppliers/employees abandoning firm, or poor investment/operating decisions decisions prior to bankruptcy or while bankruptcy is being resolved

Just the threat of bankruptcy can generate these indirect costs

Question 26

How do you account for CFD (Costs of financial distress?)

Answer 26

How to account for CFD in valuation? Use APV:
VL = VU + PV(tax shields) − PV(costs of financial distress)

Trade-off theory: Optimal capital structure is based on a trade-off between tax savings and the distress costs of debt

Question 27

Who pays bankrupcty costs?

Which are bigger, direct or indirect bankrupcty costs?

Answer 27

1) Bankruptcy costs are paid by shareholders

Why?
With bankruptcy costs, debtholders know they will get less if the firm defaults.

So they demand more (a larger face value) in the event that the firm does not default (otherwise, no lending).

This leaves less money for shareholders → value of equity decreases

2) Direct bankruptcy costs are relatively small

In the example, the expected bankruptcy costs reduce firm value by only 2.5% (1.74/69.57)

Why is this reduction in value less than the 7% (the direct bankruptcy costs above?
Bankruptcy is not a certainty
Bankruptcy occurs in the future
Riskiness of equity increases (to 79.69% from 67.88%) resulting in deeper risk-adjusted discounting

Empirically: 3-4% of assets or 20% of market value of equity at the time of bankruptcy

Direct bankruptcy costs seems second order compared with the tax shield benefit

3) Indirect bankruptcy costs can be considerably larger than the direct costs.
Indirect costs include:
Deterioration of business environment in expectation of bankruptcy:
Poorer prices for products (no guarantees)
Poorer prices from suppliers (no trade credit)
Problems hiring and retaining employees
Fire sale of assets
Poor investment decisions arising from conflicts of interest between stakeholders of the firm
Asset substitution – often manifested in risk shifting towards high-risk, negative NPV projects.
Debt overhang - under-investment in positive NPV projects. Can be facilitated by bankruptcy laws

Question 28

What are some indirect costs arising from bankruptcy?

Answer 28

Indirect bankruptcy costs can be considerably larger than the direct costs.

Indirect costs include:

Deterioration of business environment in expectation of bankruptcy:
Poorer prices for products (no guarantees)
Poorer prices from suppliers (no trade credit)
Problems hiring and retaining employees

Fire sale of assets

Poor investment decisions arising from conflicts of interest between stakeholders of the firm:
Asset substitution –> risk shifting towards high risk, negative NPV projects.
Debt overhang –> foregoing investment in postive NPV project
Can be facilitated by bankruptcy laws

Indirect costs also vary across firms/industries and the type of company’s assets:
e.g. Much lower if they are, for instance, real estate or tangible assets. Higher if assets are intangible.
Industries in which firms can more easily increase risk (e.g. growth firms) may face higher indirect costs from risk-shifting behaviour

Question 29

What are agency costs?

Answer 29

Agency costs: costs arising from conflicts of interest between stakeholders in a firm.

In firms with leverage, conflicts of interest can emerge between shareholders and debtholders when projects have different consequences for their respective payoffs.

Debtholders prefer safer projects:
They have priority in cash flow
They only care about the first X dollars

Equityholders prefer risky projects:
They are a residual claimant with limited liability. Potentially unlimited upside

The costs created by this conflict can be especially acute when a firm is already in or facing a high risk of financial distress

Question 30

What are the two well-known agency problems of debt?

Answer 30

USE NPV TO SHOW CONFLICTS.

Asset substitution/Overinvestment/Risk shifting: when debt is in place, equity has the incentive to take excessive and inefficient risks

Debt overhang/Underinvestment: when debt is in place, equity has the incentive to refuse positive NPV projects

(The conflict of interest only significant @ high levels of debt)

Question 31

Why do equity investors prefer more risk?

And Why are shareholders’ incentives to increase risk greater in financial distress?

Answer 31

Why do equity investors prefer more risk?

Levered equity → call option on the firm’s assets
Exercise price: Face value of debt
An option is more valuable if volatility/risk of the underlying (i.e. the assets) increases

Why are shareholders’ incentives to increase risk greater in financial distress?

Limited liability/downside-risk
Win: shareholders reap most of the gains
Lose: debtholders suffer most of the losses

Question 32

Why does debt overhang arise?

Answer 32

Positive NPV projects require inputs.

Equity pays the costs.

Improved cash flow largely goes to paying back debt.

Payoff to debt increases.

Gross terminal payoff to equity also increases, but net of the costs, it can decrease.

Equity pays the costs, but benefit accrues to debt. As a result, some +NPV projects are passed up.

Question 33

What are some other situation that arise during severe financial distress?

Answer 33

Cash In and Run:
When default is likely, sell assets and pay out the proceeds as big dividends. The decline in market value is shared with creditors.

Playing for Time:
Accounting manipulations to hide problems

Bait and Switch:
Issue bond, saying this is the most senior bond I issue.
Subsequently renege and issue more senior bond. (with higher priority)

Question 34

How much should a firm borrow?

Answer 34

Trade-off Theory: The optimal leverage (amount of debt) should balance the benefits and costs of debt.

How to quantify this trade-off? Use APV:
VL = VU + PV(tax shields) − PV(costs of financial distress)

where:
VL: levered value of project/firm
VU: all-equity value of project/firm
PV(tax shields): value of all tax savings from debt
PV(costs of financial distress): value of all direct and indirect costs of financial distress

Question 35

How would you calculate the present value of costs of financial distress, PV(CFD)?

Answer 35

Inputs required are estimates of:
Probability of bankruptcy (p):
Use bond rating and empirical estimates of default probability for each rating
Costs of bankruptcy (CFD):
Empirical studies of direct (3% of book assets) and indirect costs (only qualitative studies; difficult to measure)
Bond expected return (rD) A model of default:
PV(CFD) = sum of p (1 − p)^t−1 CFD/ (1+rD)t = pCFD/ rD +p

Question 36

What is assymetric information and signalling?

Answer 36

Asymmetric information: one party to a transaction has more/better information than the other.

Managers know more about their companies’ prospects, risks, and values than do outside investors.

The actions of the better informed party can help the uninformed party infer the informed party’s private information → ‘signaling’

The actions of managers can act as signals, causing the market (i.e. investors) to react.

Remember, stock prices tend to rise on the announcement of an increase in the regular dividend as investors interpret this as a credible sign of management’s confidence in future earnings

Capital structure decisions can be a signal too.

Question 37

Explain the Pecking-order theory.

Answer 37

Under symmetric information, regardless of risk: All +ve NPV projects can be implemented
When uncertainty is realised, old shareholders may win or lose, but there is no efficiency loss. They get the full NPV in expectation.
Under asymmetric information:
Investors can’t tell the quality of the firm
Pooling together with bad firms gives a low price for good firms.
This creates an adverse selection problem: when quality is unobserved, only poor quality goods are sold. In this example, only bad firms issue equity.
Efficiency loss: good firms with +ve NPV projects can’t be financed.

Managers acting optimally will issue new equity & invest in project only in bad state. (ADVERSE SELECTION PRBOBLEM.)

Potential solutions: Retained Earnings or Debt

Cash on hand: Retained earnings are cheaper than external financing because then the firm isn’t forced to forego positive NPV projects.

Risk-free debt: Suppose the company borrowed 100 risk-free to fund the project (zero discount rate)
Borrow 100, pay back 100
State 1: Shareholder payoff: 270 − 100 = 170 > 150
State 2: Shareholder payoff: 160 − 100 = 60 > 50
In both states, the firm has the incentive to borrow and invest in the project.

Intuition: the value of debt is less sensitive to private information than equity.

Pecking order theory: When financing projects, firms prefer to use the least information-sensitive securities first.

Logic: if the value of a security depends a lot on your private information, it suffers from adverse selection problems. The issue of securities is a signal that those securities are overpriced.
Pecking order:
1 Least sensitive: Retained earnings (cash), risk-free debt
2 Median: Risky debt
3 Most sensitive: Equity

Question 38

Explain the agency conflict between shareholders and managers. (AGENCY PROBLEM.)

Answer 38

Agency conflict: Managers vs Shareholders (DROPPING INVESTMENT IS HELD CONSTANT & MANAGERS MAXIMISE SHAREHOLDER WEALTH.)

Key feature of large public corporations: Separation of ownership and control:
Managers have direct control over day-to-day operations but they dont have much equity
Most outside equity holders dont run the firm
This feature can create conflicts of interest between managers and other equity holders

Agency Problem: Managers may be self-interested and exploit equity investors

Managers are self-interested
They only bear a small cost (proportional to their ownership). But they enjoy the full benefit.
One solution: align managers’ incentives with interests of shareholders
Extreme case: Let manager own the entire firm
Use high-powered incentive contracts, e.g. options. Not a silver bullet: short-termism, excessive risk-taking

Question 39

What kind of comapnies are more likely to suffer from the Agency problem?

Answer 39

(AGENCY COST OF FREE CASH FLOW.)
Free Cash Flow: cash flow in excess of amount needed to fund all positive NPV projects

FCF should be paid out to investors.

FCF can potentially be wasted by managers on personal perks or vanity projects.

The agency problem in the firms context is also referred to as the ‘agency cost of free-cash-flow’.

Solution

Dividends and repurchases could work but are imperfect
Debt is a legal commitment to pay out cash flow
A company carrying debt will have less free-cash-flow to waste.

If the company goes bankrupt, the manager will often be fired. Therefore, debt obligations can act as a disciplining mechanism:

Managers work harder and often smarter in companies with large debt since they need to generate cash for debt service, e.g. LBO/private equity

Implications on capital structure:
Optimal debt levels would leave just enough cash in the bank, after debt service, to finance all positive-NPV projects

Question 40

What are the Four theories of Capital structure?

Answer 40

Baseline: MM Capital Structure Irrelevance in perfect capital markets

When markets are not perfect (i.e. all the time):

Trade-off theory:
Tax benefits vs. bankruptcy costs

Pecking order theory:
Avoid adverse selection costs of asymmetric information by exhausting cash and risk-free debt first, then risky debt, then equity

Agency theory:
Use debt to alleviate manager vs shareholder agency problem and force pay out