2011 Finance Lecture 2

The Financing Decision
Finance Week 2 The Capital Structure and Financing Decision

Gavin Kretzschmar1,
1
Accounting and Finance Group

2
University of Edinburgh
2010 - 2011 FTMBA Cadre
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Gavin Kretzschmar, Axel Kirchner The Capital Structure and Financing Decision
Leverage Fundamental Analysis Modigliani-Miller and the real world Equity Financing Decisions
This week
Financing Chapter 6, Higgins (2009)
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Choices
If a rm requires $200 million in external nancing, should it issue new debt or new equity? If equity nancing is not an alternative, how much debt should the rm issue? How does the rms nancing decision today impact its situation in the future?
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Things to Keep in Mind
Do not assume there is a single right answer to any of these questions. OPM is other peoples money. How does OPM affect risk-return relationships in a corporate setting? tax implications? nancial distress? signaling effects?
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Outline
The Financing Decision Leverage Fundamental Analysis Modigliani-Miller and the real world Equity Financing Decisions
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Example
Examine Table 6-1. $1,000 outlay. Two possible investment outcomes. Probabilities are 50-50. Panel A illustrates 100% equity nancing. Panel B illustrates debt nancing. How does debt nancing impact the return to owners (shareholders) in the two outcomes, and on average?
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Debt Financing Increases Expected Return (and Risk!!) to Owners
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The Bottom Line
Increased debt lowers the initial investment required by shareholders. Increased debt amplies the expected return. Increased debt amplies the risk faced by shareholders. Thats what nancial leverage is all about. Operating leverage, featuring high xed costs, but low variable costs, works the same way.
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Key Equation
ROE = ROIC + (ROIC - i) (D/E) Here i is the after-tax cost of debt (1-t)i. The equation can be derived using the denition of ROE as [(EBIT - tD)(1-t)]/E, and ROIC = EBIT(1-t)/(D+E). Notice that for an unlevered rm, ROE is just ROIC. Leverage modies ROIC, where the modication is proportional to D/E.
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Favourable and Unfavourable Outcomes
ROE = ROIC + (ROIC - i) (D/E) ROIC < i is not good for a company, since its assets generate a return that does not cover the after-tax cost of debt. ROIC > i in favorable events, in which case ROE > ROIC. ROIC < i in unfavorable events, in which case ROE < ROIC.
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Its Not So Easy
In 2007, a pretty good year for corporate prots, 47% of large publicly traded rms tracked by S&P 500 accomplished this feat. For larger rms with sales above $200 million, 78% accomplished this feat. Figure 6-1 illustrates the impact of leverage on both risk and expected return.
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Impact of leverage on both risk and expected return
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Highlights
Leverage shifts expected return to the right. Leverage attens the distribution, shifting probability to the extremes. Bankruptcy lies at the left extreme. Leverage of 2-to-1 pushes the lower tail from -12 to -40 for the same operating income.
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Outline
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Analysis
Can use pro forma analysis. Can use ratios. Important to gross up after-tax amounts to before tax-amounts by dividing after-tax amounts by 1-t, where t is the corporate tax rate. Look at 3 coverage ratios, involving the payment of interest, principal, and dividends, where coverage is for 1, top 2, or all 3 payments. % EBIT Can Fall When a coverage ratio drops below 1.0, the company is in danger of not being able to make its payments from operating cash ows. Ask by what % EBIT can fall before a ratio drops to 1.0. The larger the % EBIT can drop, the less the risk the company faces. Consider how debt nancing impacts % EBIT can fall.
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Compare With Industry Figures
How do D/A and TIE vary across industries? See Table 6-4. Keep in mind that there was a recession in 2001. How do the rms ratios stack up against the industry data? Table 6-5 enables the rm to ballpark itself in respect to bond rating.
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How do D/A and TIE vary across industries?
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How do D/A and TIE vary by bond rating?
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Leverage and Earnings
How are the two nancing schemes likely to affect reported income and ROE? To answer this question, look at pro forma statements for the two plans, under two different conditions, boom and bust. See Table 6-6. This table displays the bottom portion of a pro forma income statement.
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Items to Look For
The difference in tax bill. If t = tax rate and I=interest payment, then the product txI measures the tax savings or tax shield from debt. Which alternative leads to higher overall earnings, debt or equity? Which alternative leads to higher EPS, ROIC, and ROE? Is it different for boom and bust?
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Crossover Analysis
Figure 6-2 in the next slide illustrates how variation in EBIT impacts EPS. Because EPS is ROE scaled up by the amount of shareholders equity, the linear relationship between ROE and ROIC carries over to EPS and EBIT. Look for the bust point, the boom point, the crossover, and the expected EBIT point. What do the differing slopes tell us?
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How variation in EBIT impacts EPS
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Outline
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How Much to Borrow?
What level of debt nancing is best for a rm? M-M principle is that in the absence of taxes and transaction costs, the rms debt levels does not impact value. Total cash ows generated over time are the basis for the rms value. The debt-equity split only determines how this value is apportioned between holders of debt and holders of equity.
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Leverage and Financing
Target leverage The lowest WACC possible Capital optimality is determined by optimally weighting debt/ prefs and equity issues Recap:
Bonds lowest cost Preference shares mix between bonds and equities Equities highest risk highest return
Each capital provider shares the Income statement - the problem is that M&M & reality conict - on two points- over taxation and insolvency costs - (see Page 210)
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Real World Issues
Taxes and transaction costs are part of the real world. What are the various items to take into consideration when making decisions about nancing with debt or equity? Table 6-3 provides a capsule summary.
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The Higgins 5-Factor Model for Financing Decisions
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Tax Benets
Interest is tax deductible. Lowering the tax bill leaves more left over for all investors, meaning the pool of shareholders and debtholders.
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Distress Costs
Increased debt leads to higher expected costs associated with nancial distress. Bankruptcy costsdebt can turn a mild inconvenience into a major problem involving major legal expenses and/or the sale of company assets at re sale prices
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Summary Checklist
When making nancing choices, keep the following in mind: The ability of the company to use additional interest tax shields over the life of the debt. The increased probability of bankruptcy stemming from added leverage. The cost to the rm if bankruptcy occurs.
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Flexibility
Credit squeezes happen. A rm might not be able to borrow to stay competitive, when it needs it most to fund an important investment opportunity. For this reason, rm managers must think about being nancial exible. Cash is king, so nance while its possible, using equity if its available and not too expensive.
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Issue Debt or Restrict Growth?
Remember that g = PRAT - see Higgins Chapter 4, where T is based on prior shareholders equity. The connection to nancing is through R and T. Increasing retention and increasing leverage both lead to increased g. Therefore, the rm faces a tradeoff, since issuing less debt and paying additional dividends to shareholders will lower growth.
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What is the Prudent Thing to Do?
Financial managers should recognize the true risks they confront, and balance the benets of higher leverage against the costs of higher leverage. Too high a T will heighten the risk that critical management decisions will fall into the hands of creditors, who have interests of their own.
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Outline
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Equity and Flexibility
Remember that nancial exibility might argue for equity nancing. Lenders are wary about lending to companies whose D/E ratio is already high, because the probability of default for these rms is higher. Keeping D/E on the low side serves as a buffer, to help the rm raise new debt more easily if necessary.
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Market Signaling
When companies announce that they intend to raise new equity, their stock prices drop. On average, the drop in value is about one third the size of the new issue. Announcements about new debt have a much more neutral impact. Announcements about stock repurchases result in a stock price increase.
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Dilution?
Does issuing new equity lower EPS? It can, if earnings stay the same but the number of shares goes up. But why would earnings stay the same if the money raised from the new stock issue was put to good use?
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Rosy Outlook
If the outlook is rosy, then relative to what they would be otherwise, increased leverage raises g increases EPS Look again at Figure 6.2. If the outlook is not rosy, then increased equity produces these same two effects. Therefore, what does a new equity issue suggest?
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Outline
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Pecking Order
Managers might respond with a pecking order rule. They fund new projects with cash, before turning to external sources. If they fund externally, they fund rst with debt. They use equity only as a last resort.
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Financing Decision and Growth
The nancing decision should weigh the relative importance of the ve factors. For rapidly growing businesses, remember to make nancing subservient to operations as a source of value creation. This means prudent debt policies.
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What Prudence Means
Conservative leverage ratio with ample unused borrowing capacity. A modest dividend payout policy to preserve cash. If investment needs temporarily > funds generated by internal operations, draw down cash and use debt as a backstop.
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Benets of Debt
Increased interest tax shields, if the company is protable. The share repurchase announcement will be warmly greeted by the market, and the rms stock price will go up. The higher debt will inject additional discipline in respect to management incentives.
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Selecting a Maturity Structure
What is the right maturity for debt? The minimum risk maturity structure is to match the maturity of the liabilities against the maturity of the operating income from the rms assets. This makes the liabilities self-liquidating. If the debt matures too soon, there is renancing risk. If the debt matures too late, the company must manage the cash until maturity.
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Order of Financing Optimality

Firms prefer internal nance. They adapt their target dividend payout ratios to investment opportunities, while avoiding sudden changes in dividend. Sticky dividend policies and volatility means capital budgeting surpluses and decits. If external nance is required, rms issue the safest security rst (debt, then hybrids - convertibles, then equity) There is no dened target debt-equity mix - only a quandary about what we need for Capital providers as a return and for Growth! note the contradiction between the ranking of internal equity and external equity
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2011 Finance Lecture 2

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2011 Finance Lecture 2

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The Financing Decision

Finance Week 2 The Capital Structure and Financing Decision

Accounting and Finance Group

2010 - 2011 FTMBA Cadre

The Financing Decision

Financing Chapter 6, Higgins (2009)

The Financing Decision

The Financing Decision

Things to Keep in Mind

The Financing Decision

The Financing Decision

The Financing Decision

Debt Financing Increases Expected Return (and Risk!!) to Owners

The Financing Decision

The Financing Decision

The Bottom Line

The Financing Decision

The Financing Decision

Favourable and Unfavourable Outcomes

The Financing Decision

Its Not So Easy

The Financing Decision

Impact of leverage on both risk and expected return

The Financing Decision

The Financing Decision

The Financing Decision

The Financing Decision

Compare With Industry Figures

The Financing Decision

How do D/A and TIE vary across industries?

The Financing Decision

How do D/A and TIE vary by bond rating?

The Financing Decision

Leverage and Earnings

The Financing Decision

The Financing Decision

Items to Look For

The Financing Decision

The Financing Decision

How variation in EBIT impacts EPS

The Financing Decision

The Financing Decision

How Much to Borrow?

The Financing Decision

Leverage and Financing

The Financing Decision

Real World Issues

The Financing Decision

The Financing Decision

The Higgins 5-Factor Model for Financing Decisions

The Financing Decision

The Financing Decision

The Financing Decision

The Financing Decision

The Financing Decision

Issue Debt or Restrict Growth?

The Financing Decision

What is the Prudent Thing to Do?

The Financing Decision

The Financing Decision

Equity and Flexibility

The Financing Decision

The Financing Decision