Kế toán, kiểm toán - Chapter 15: Capital structure decisions: Part I

Chapter 15Capital Structure Decisions: Part I1Topics in ChapterOverview and preview of capital structure effectsBusiness versus financial riskThe impact of debt on returnsCapital structure theory, evidence, and implications for managersExample: Choosing the optimal structure2Basic DefinitionsV = value of firmFCF = free cash flowWACC = weighted average cost of capitalrs and rd are costs of stock and debtwce and wd are percentages of the firm that are financed with stock and debt.3How can capital structure affect value?V=∑∞t=1FCFt(1 + WACC)tWACC= wd (1-T) rd + wcers4A Preview of Capital Structure EffectsThe impact of capital structure on value depends upon the effect of debt on:WACCFCF(Continued)5The Effect of Additional Debt on WACCDebtholders have a prior claim on cash flows relative to stockholders. Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.Cost of stock, rs, goes up.Firm’s can deduct interest expenses.Reduces the taxes paidFrees up more cash for payments to investorsReduces after-tax cost of debt(Continued)6The Effect on WACC (Continued)Debt increases risk of bankruptcyCauses pre-tax cost of debt, rd, to increaseAdding debt increase percent of firm financed with low-cost debt (wd) and decreases percent financed with high-cost equity (wce)Net effect on WACC = uncertain.(Continued)7The Effect of Additional Debt on FCFAdditional debt increases the probability of bankruptcy.Direct costs: Legal fees, “fire” sales, etc.Indirect costs: Lost customers, reduction in productivity of managers and line workers, reduction in credit (i.e., accounts payable) offered by suppliers (Continued)8Impact of indirect costsNOPAT goes down due to lost customers and drop in productivityInvestment in capital goes up due to increase in net operating working capital (accounts payable goes down as suppliers tighten credit).(Continued)9Additional debt can affect the behavior of managers.Reductions in agency costs: debt “pre-commits,” or “bonds,” free cash flow for use in making interest payments. Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions.Increases in agency costs: debt can make managers too risk-averse, causing “underinvestment” in risky but positive NPV projects. (Continued)10Asymmetric Information and SignalingManagers know the firm’s future prospects better than investors.Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information).Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls. 11Business risk: Uncertainty about future pre-tax operating income (EBIT).ProbabilityEBITE(EBIT)0Low riskHigh riskNote that business risk focuses on operating income, so it ignores financing effects.12Factors That Influence Business RiskUncertainty about demand (unit sales).Uncertainty about output prices.Uncertainty about input costs.Product and other types of liability.Degree of operating leverage (DOL).13What is operating leverage, and how does it affect a firm’s business risk?Operating leverage is the change in EBIT caused by a change in quantity sold.The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.(More...)14Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline.(More...)Sales$Rev.TCFQBEEBIT}$Rev.TCFQBESales15Operating BreakevenQ is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit.Operating breakeven = QBEQBE = F / (P – V)Example: F=$200, P=$15, and V=$10:QBE = $200 / ($15 – $10) = 40.(More...)16ProbabilityEBITLLow operating leverageHigh operating leverageEBITHHigher operating leverage leads to higher expected EBIT and higher risk.17Business Risk versus Financial RiskBusiness risk:Uncertainty in future EBIT.Depends on business factors such as competition, operating leverage, etc.Financial risk:Additional business risk concentrated on common stockholders when financial leverage is used.Depends on the amount of debt and preferred stock financing.18Consider Two Hypothetical FirmsFirm UFirm LNo debt $10,000 of 12% debt$20,000 in assets$20,000 in assets40% tax rate 40% tax rateBoth firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.19Impact of Leverage on ReturnsFirm UFirm LEBIT $3,000$3,000Interest 0 1,200EBT $3,000$1,800Taxes (40%)1 ,200720NI $1,800$1,080ROE9.0%10.8%20Why does leveraging increase return?More EBIT goes to investors in Firm L.Total dollars paid to investors:U: NI = $1,800.L: NI + Int = $1,080 + $1,200 = $2,280.Taxes paid:U: $1,200; L: $720.Equity $ proportionally lower than NI.21ContinuedNow consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L?22Firm U: UnleveragedEconomyBadAvg.GoodProb.0.250.500.25EBIT$2,000$3,000$4,000Interest 0 0 0EBT$2,000$3,000$4,000Taxes(40%) 800 1,200 1,600NI$1,200$1,800$2,40023Firm L: LeveragedEconomyBadAvg.GoodProb.*0.250.500.25EBIT$2,000$3,000$4,000Interest 1,200 1,200 1,200EBT$ 800$1,800$2,800Taxes(40%) 320 720 1,120NI$ 480$1,080$1,680*same as for Firm U24Firm UBadAvg. GoodBEP10.0%15.0%20.0%ROIC6.0%9.0%12.0%ROE6.0%9.0%12.0%TIEn.a.n.a.n.a.Firm LBad Avg.GoodBEP10.0%15.0%20.0%ROIC6.0%9.0%12.0%ROE4.8%10.8%16.8%TIE1.72.53.325Profitability Measures:ULE(BEP)15.0%15.0%E(ROIC)9.0%9.0%E(ROE)9.0%10.8%Risk Measures:σROIC2.12%2.12%σROE2.12%4.24%26ConclusionsBasic earning power (EBIT/TA) and ROIC (NOPAT/Capital = EBIT(1-T)/TA) are unaffected by financial leverage.L has higher expected ROE: tax savings and smaller equity base.L has much wider ROE swings because of fixed interest charges. Higher expected return is accompanied by higher risk.(More...)27In a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s.U and L: σROIC = 2.12%.U: σROE = 2.12%. L: σROE = 4.24%.L’s financial risk is σROE - σROIC = 4.24% - 2.12% = 2.12%. (U’s is zero.)(More...)28For leverage to be positive (increase expected ROE), BEP must be > rd.If rd > BEP, the cost of leveraging will be higher than the inherent profitability of the assets, so the use of financial leverage will depress net income and ROE.In the example, E(BEP) = 15% while interest rate = 12%, so leveraging “works.”29Capital Structure TheoryMM theoryZero taxesCorporate taxesCorporate and personal taxesTrade-off theorySignaling theoryPecking orderDebt financing as a managerial constraintWindows of opportunity30MM Theory: Zero TaxesFirm UFirm LEBIT $3,000$3,000Interest 0 1,200NI $3,000$1,800CF to shareholder$3,000$1,800CF to debtholder 0$1,200Total CF$3,000$3,000Notice that the total CF are identical.31MM Results: Zero TaxesMM assume: (1) no transactions costs; (2) no restrictions or costs to short sales; and (3) individuals can borrow at the same rate as corporations.Under these assumptions, MM prove that if the total CF to investors of Firm U and Firm L are equal, then the total values of Firm U and Firm L must be equal: VL = VU.Because FCF and values of firms L and U are equal, their WACCs are equal.Therefore, capital structure is irrelevant.32MM Theory: Corporate TaxesCorporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms.Therefore, more CF goes to investors and less to taxes when leverage is used.In other words, the debt “shields” some of the firm’s CF from taxes.33MM Result: Corporate TaxesMM show that the total CF to Firm L’s investors is equal to the total CF to Firm U’s investor plus an additional amount due to interest deductibility: CFL = CFU + rdDT.MM then show that: VL = VU + TD.If T=40%, then every dollar of debt adds 40 cents of extra value to firm.34Value of Firm, V0 DebtVLVUUnder MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.TDMM relationship between value and debt when corporate taxes are considered.35Cost of Capital (%)0 20 40 60 80 100Debt/Value Ratio (%)rsWACCrd(1 - T)MM relationship between capital costs and leverage when corporate taxes are considered.36Miller’s Theory: Corporate and Personal TaxesPersonal taxes lessen the advantage of corporate debt:Corporate taxes favor debt financing since corporations can deduct interest expenses.Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.37Miller’s Model with Corporate and Personal TaxesVL = VU + 1− DTc = corporate tax rate.Td = personal tax rate on debt income.Ts = personal tax rate on stock income.(1 - Tc)(1 - Ts)(1 - Td)38Tc = 40%, Td = 30%, and Ts = 12%.VL = VU + 1− D = VU + (1 - 0.75)D = VU + 0.25D.Value rises with debt; each $1 increase in debt raises L’s value by $0.25.(1 - 0.40)(1 - 0.12)(1 - 0.30)39Conclusions with Personal TaxesUse of debt financing remains advantageous, but benefits are less than under only corporate taxes.Firms should still use 100% debt.Note: However, Miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to debt.40Trade-off TheoryMM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.At low leverage levels, tax benefits outweigh bankruptcy costs.At high levels, bankruptcy costs outweigh tax benefits.An optimal capital structure exists that balances these costs and benefits.41Signaling TheoryMM assumed that investors and managers have the same information.But, managers often have better information. Thus, they would:Sell stock if stock is overvalued.Sell bonds if stock is undervalued.Investors understand this, so view new stock sales as a negative signal.Implications for managers?42Pecking Order TheoryFirms use internally generated funds first, because there are no flotation costs or negative signals.If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals.If more funds are needed, firms then issue equity.43Debt Financing and Agency CostsOne agency problem is that managers can use corporate funds for non-value maximizing purposes.The use of financial leverage:Bonds “free cash flow.”Forces discipline on managers to avoid perks and non-value adding acquisitions.(More...)44A second agency problem is the potential for “underinvestment”.Debt increases risk of financial distress.Therefore, managers may avoid risky projects even if they have positive NPVs. 45Investment Opportunity Set and Reserve Borrowing CapacityFirms with many investment opportunities should maintain reserve borrowing capacity, especially if they have problems with asymmetric information (which would cause equity issues to be costly).46Windows of OpportunityManagers try to “time the market” when issuing securities.They issue equity when the market is “high” and after big stock price run ups.They issue debt when the stock market is “low” and when interest rates are “low.”The issue short-term debt when the term structure is upward sloping and long-term debt when it is relatively flat.47Empirical EvidenceTax benefits are important– $1 debt adds about $0.10 to value.Supports Miller model with personal taxes.Bankruptcies are costly– costs can be up to 10% to 20% of firm value.Firms don’t make quick corrections when stock price changes cause their debt ratios to change– doesn’t support trade-off model.48Empirical Evidence (Continued)After big stock price run ups, debt ratio falls, but firms tend to issue equity instead of debt.Inconsistent with trade-off model.Inconsistent with pecking order.Consistent with windows of opportunity.Many firms, especially those with growth options and asymmetric information problems, tend to maintain excess borrowing capacity.49Implications for ManagersTake advantage of tax benefits by issuing debt, especially if the firm has:High tax rateStable salesLess operating leverage50Implications for Managers (Continued)Avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has:Volatile salesHigh operating leverageMany potential investment opportunitiesSpecial purpose assets (instead of general purpose assets that make good collateral)51Implications for Managers (Continued)If manager has asymmetric information regarding firm’s future prospects, then avoid issuing equity if actual prospects are better than the market perceives.Always consider the impact of capital structure choices on lenders’ and rating agencies’ attitudes52Choosing the Optimal Capital Structure: ExampleCurrently is all-equity financed. Expected EBIT = $500,000.Firm expects zero growth.100,000 shares outstanding; rs = 12%; P0 = $25; T = 40%; b = 1.0; rRF = 6%; RPM = 6%.53Estimates of Cost of Debt% financed with debt, wdrd0%-20%8.0%30%8.5%40%10.0%50%12.0%If company recapitalizes, debt would be issued to repurchase stock.54The Cost of Equity at Different Levels of Debt: Hamada’s Equation MM theory implies that beta changes with leverage.bU is the beta of a firm when it has no debt (the unlevered beta)b = bU [1 + (1 - T)(D/S)]55The Cost of Equity for wd = 20%Use Hamada’s equation to find beta: b = bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%) ] = 1.15Use CAPM to find the cost of equity: rs= rRF + bL (RPM) = 6% + 1.15 (6%) = 12.9%56Cost of Equity vs. Leveragewd D/Sb rs0% 0.001.00012.00%20% 0.251.15012.90%30% 0.431.25713.54%40% 0.671.40014.40%50% 1.001.60015.60%57The WACC for wd = 20%WACC = wd (1-T) rd + wce rsWACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)WACC = 11.28%Repeat this for all capital structures under consideration.58WACC vs. LeveragewdrdrsWACC0%0.0%12.00%12.00%20%8.0%12.90%11.28%30%8.5%13.54%11.01%40%10.0%14.40%11.04%50%12.0%15.60%11.40%59Corporate Value for wd = 20%Vop = FCF(1+g) / (WACC-g)g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T).NOPAT = ($500,000)(1-0.40) = $300,000.Vop = $300,000 / 0.1128 = $2,659,574.60Corporate Value vs. LeveragewdWACCCorp. Value0%12.00%$2,500,00020%11.28%$2,659,57430%11.01%$2,724,79640%11.04%$2,717,39150%11.40%$2,631,57961Debt for wd = 20%The dollar value of debt is: D = wd V = 0.2 ($2,659,574) = $531,915. 62Debt vs. LeveragewdDebt, D0%$020%$531,91530%$817,43940%$1,086,95750%$1,315,789(Note: these are rounded; see IFM10 Ch15 Mini Case.xls for full calculations.)63Anatomy of a Recap: Before Issuing Debt Before Debt Vop$2,500,000 + ST Inv. 0 VTotal$2,500,000 − Debt 0S$2,500,000 ÷ n100,000 P$25.00 Total shareholderwealth: S + Cash$2,500,000 64Issue Debt (wd = 20%), But Before RepurchaseWACC decreases to 11.28%.Vop increases to $2,659,574.Firm temporarily has short-term investments of $531,915 (until it uses these funds to repurchase stock).Debt is now $531,915.65Anatomy of a Recap: After Debt, but Before Repurchase Before DebtAfter Debt, Before Rep. Vop$2,500,000 $2,659,574 + ST Inv. 0531,915 VTotal$2,500,000 $3,191,489 − Debt 0531,915S$2,500,000 $2,659,574 ÷ n100,000 100,000 P$25.00 $26.60 Total shareholderwealth: S + Cash$2,500,000 $2,659,574 66After Issuing Debt, Before Repurchasing StockStock price increases from $25.00 to $26.60.Wealth of shareholders (due to ownership of equity) increases from $2,500,000 to $2,659,574. 67The Repurchase: No Effect on Stock PriceThe announcement of an intended repurchase might send a signal that affects stock price, and the previous change in capital structure affects stock price, but the repurchase itself has no impact on stock price.If investors thought that the repurchase would increase the stock price, they would all purchase stock the day before, which would drive up its price. If investors thought that the repurchase would decrease the stock price, they would all sell short the stock the day before, which would drive down the stock price.68Remaining Number of Shares After RepurchaseD0 is amount of debt the firm initially has, D is amount after issuing new debt.If all new debt is used to repurchase shares, then total dollars used equals (D – D0) = ($531,915 - $0) = $531,915.n0 is number of shares before repurchase, n is number after. Total shares remaining:n = n0 – (D – D0)/P = 100,000 - $531,915/$26.60n = 80,000(Ignore rounding differences; see IFM10 Ch15 Mini Case.xls for actual calculations).69Anatomy of a Recap: After Rupurchase Before DebtAfter Debt, Before Rep.After Rep. Vop$2,500,000 $2,659,574 $2,659,574 + ST Inv. 0531,915 0 VTotal$2,500,000 $3,191,489 $2,659,574 − Debt 0531,915531,915S$2,500,000 $2,659,574 $2,127,660 ÷ n100,000 100,000 80,000 P$25.00 $26.60 $26.60 Total shareholderwealth: S + Cash$2,500,000 $2,659,574 $2,659,574 70Key PointsST investments fall because they are used to repurchase stock.Stock price is unchanged.Value of equity falls from $2,659,574 to $2,127,660 because firm no longer owns the ST investments.Wealth of shareholders remains at $2,659,574 because shareholders now directly own the funds that were held by firm in ST investments.71ShortcutsThe corporate valuation approach will always give the correct answer, but there are some shortcuts for finding S, P, and n.Shortcuts on next slides.72Calculating S, the Value of Equity after the RecapS = (1 – wd) VopAt wd = 20%:S = (1 – 0.20) $2,659,574S = $2,127,660.(Ignore rounding differences; see IFM10 Ch15 Mini Case.xls for actual calculations).73Calculating P, the Stock Price after the Recap P = [S + (D – D0)]/n0 P = $2,127,660 + ($531,915 – 0) 100,000 P = $26.596 per share.74Number of Shares after a Repurchase, n# Repurchased = (D - D0) / Pn = n0 - (D - D0) / P# Rep. = ($531,915 – 0) / $26.596# Rep. = 20,000. n = 100,000 – 20,000n = 80,000.75Price per Share vs. LeveragewdS Pn0%$2,500,000$25.00100,00020%$2,127,660$26.6080,00030%$1,907,357$27.2570,00040%$1,630,435$27.1760,00050%$1,315,789$26.3250,00076Optimal Capital Structurewd = 30% gives:Highest corporate valueLowest WACCHighest stock price per shareBut wd = 40% is close. Optimal range is pretty flat.77