Capital Structure and Firm

Value
Does Capital Structure affect value?
• Empirical patterns
– Across Industries
– Across Firms
– Across Years
– Who has lower debt?
• High intangible assets/specialized assets
• High growth firms
• High cash flow volatility
• High information asymmetry
• Industry leaders

• Is capital structure managed?

– If so much time is spent on capital structure then there
must be some value to it (or managers/investors are
irrational)
 Debt and Equity Only?
• Typically thought of and measured this way
• Much more complex
– Investment opportunities and strategy (needs)
– Financing (sources)
• Cash balance
• Distribution: Dividend and repurchases
• Debt capacity
• Equity capacity
• Existing debt and equity
– Other financial policies: Financial Hedging, Cash
Flow Volatility, Forms of Compensation
 How does capital structure affect
value?
• To prove this we start in the “perfect world”
– Based on the work of Miller and Modigliani
– Shows that capital structure is irrelevant

• Value is derived from market imperfections

• Example: What if a firm is considering

issuing debt and retiring equal amounts of
equity?
 Current Proposed
Assets 8000 8000
Debt 0 4000
Equity 8000 4000
Interest 0.1 0.1
Share Price 20 20
Outstanding Shares 400 200
Current Recession Expected Expansion
Earnings 400 1200 2000
ROA 0.05 0.15 0.25
ROE 0.05 0.15 0.25
EPS 1 3 5

Proposed Recession Expected Expansion

EBI 400 1200 2000
Interest 400 400 400
Earnings 0 800 1600
ROA 0.05 0.15 0.25
ROE 0 0.2 0.4
EPS 0 4 8
 Position #1: Buy 100 shares of the levered firm
($20*100=$2,000 Initial Investment)

Recession Expected Expansion

Earnings 0 400 800

Position #2: Buy 200 shares of the unlevered firm and borrow
$2000 (($20*200)-$2,000=$2,000 Initial investment).

Recession Expected Expansion

Earnings 200 600 1000
Interest 200 200 200
Net Earnings 0 400 800
Capital Structure is Irrelevant

• Miller and Modigliani assume perfect

capital markets

• Proposition #1: The market value of any

firm is independent of its capital structure.
 Firm Value: Perfect Capital Markets

190

170

150

130
Value

V(Unlevered)

110

90

70

50
0% 25% 50% 75% 100%
D/E
 Market Imperfections: Taxes
• Taxes
– US Tax Code: Deductibility of interest leads to
lower cost of debt (Rd(1-t))
– Simple specification overvalues benefit
• Ignores personal taxes which
– Decreases investors debt return
– Increases investors preference for equity
 Capital gains: Defer and rate difference
 Dividend: Some portion is deductible
Market Imperfections: Contracting Costs
• In imperfect markets, alternative ways to
contract optimal behavior are necessary
• Costs of financial distress
– Underinvestment (rejecting NPV>0 projects),
direct, indirect costs, etc.
• Benefits of debt
– Monitoring function, manages free cash flow
problem (Accepting NPV<0 projects), etc.
• Contracting costs and taxes are primary
motives for static trade off theory debt
Market Imperfections: Information Costs

• With asymmetric information, leverage may reveal

something about the existing firm
• Market timing: Managers take advantage of
superior information
– Issue equity when it is overvalued
– Issue debt when it is undervalued
• Signaling: Managers use financing to signal future
prospects of firms
– Issue equity to signal good growth opportunities
(preserve financial flexibility)
– Issue debt when expected cash flows are strong and
stable
• Motivates Pecking Order Theory
 Can we quantify the value of
market imperfections?
Debt adds value to the firm due to the
interest deductibility (assume taxes only)
VL  VU  PV (TaxShield )

Assume the simple case:

rD D C
PV (TaxShield )   D C
rD
 Firm Value: Perfect Capital Markets

190

170

150

130
Value

V(Unlevered)
V(Levered)

110

90

70

50
0% 25% 50% 75% 100%
D/E
 More Complex Tax Shields

• Uneven and/or limited time payments

– Discount all flows back to time 0

• What r do you use?

– Certain the tax shield can be used: rD
– Uncertain? Higher r
 Financial Distress

• As leverage increases, the probability

therefore PV of financial distress increases

VL  VU  PV (TaxShield )  PV ( FinancialD istressCos t )

• How do we estimate the cost of distress?

– Prob(Distress)*Cost of Distress
• Probability can be estimated in several ways
– Logit/Probit regressions
– Debt ratings
 Firm Value: with Taxes and Fiancial Distress

190

170

150

130 V(Unlevered)
V(Levered)
V(Distress)

110

90

70

50
D/E
D/E
Financial Distress: Bankruptcy Costs
• Direct Costs
– Legal, accounting and other professional fees
– Re-organization losses
– Estimated btw 4-10% of firm value (t-3)
• Indirect Costs
– Reputation costs
– Market share
– Operating losses
– Estimated as 7.8% of firm value (t-2)
Financial Distress: Agency Costs

• Risk shifting and asset substitution

– Shareholders invest in high risk projects and
shift risk to the debt holders
– Shareholders issue more debt, diminishing old
debt holders protection
• Underinvestment
• Expropriating funds
• Difficult to estimate
 Other Advantages of Debt
• Agency cost of Equity (motive)
– Shirking is less likely when issuing debt
– Perquisites are less likely with debt
– Over-investment is less likely with debt
• Agency cost of Free Cash Flow (opportunity)
– Retained earnings versus dividends?
– Growth and investment opportunities
• Debt serves as a monitoring device,
decreasing managerial discretion
• Bankruptcy as a strategic move???
Formal Models of Capital Structure
• Pecking Order
– Firms prefer to raise capital
• Internally generated funds
• Debt
• Equity
– Implies capital structure is derived from
• Financing needs and capital availability
• Dynamic rather than static
• Asymmetric information and signaling
• Static Trade Off
Static trade-off theory of debt
Firm Value

Maximum
Firm Value

Actual Firm Value

Debt

Optimal amount of Debt

Implications of Static Trade Off
• Static rather than dynamic
• Taxes and Contracting Cost drive value
• Readjustment may be sticky
– Optimal trade off between cost of issuances and
benefit of capital structure
• Insights
– Large, stable profit firms will have more debt
– Higher the costs of distress lower debt
– Lower taxes, lower debt
– Less (more) favorable tax treatment of debt (equity),
lower debt
 Evidence: Taxes
• This method usually overestimates the tax
consequence
– Magnitude of leverage differences across
countries and tax regimes is not that big
– Equity taxes (personal taxes) are
overestimated (Miller)
• Timing of capital gains
• Higher effective marginal tax rate, higher
the leverage (Graham, 2001)
 Evidence
• Contracting Costs: Consistent evidence
– Higher (lower) the growth opportunities, higher (lower)
the potential underinvestment problem, lower (higher)
the leverage
– Higher growth opportunities would prefer
• Shorter maturity debt (or call provisions)
• Less restrictive covenants
• More convertibility provisions
• More concentrated investors (private)
• Information costs
– Consistent with market timing (SEO’s lead to -3% return)
– Inconsistent with signaling and pecking order
• Taxes: Higher effective marginal tax rate, higher
the leverage
 MM: Proposition II
• How does leverage affect rE
• Start with the WACC E D
ra  rE  rD
V V
• Solve for rE
D
rE  ra  (ra  rD )
E
• The rate of return on the equity of a firm increases
in proportion to the debt to equity ratio (D/E).
MM: Proposition II (with taxes)

E D
ra  rE  (1   c )rD
V V
D
rE  ra  (1   c )( ra  rD )
E
• Blue Inc. has no debt and is expected to generate $4
million in EBIT in perpetuity. Tc=30%. All after-tax
earnings are paid as dividends.The firm is considering
a restructuring, with a perpetual fixed $10 million in
floating rate debt at an expected interest rate of 8%.
The unlevered cost of equity is 18%.

• What is the current value of Blue?

• What will the new value be after the restructuring?
• What will the new required return on equity be?

• What if we use the new WACC?

What About Financial Flexibility?
• The ability to quickly change the level and
type of financing

• Value increasing if
– Growth opportunities exist
– Company is willing to exercise and extinguish
future flexibility
– New investments are unpredictable and large
– Precautionary debt ratings cushion is valuable
• Value destroying if the opposite is true
How do we value financial flexibility?
 What do we do?
• Choosing a target capital structure
– Minimize taxes and contracting costs (while paying
attention to information costs)
– Target ratio should reflect the company’s
• Expected investment requirements
• Level and stability of cash flows
• Tax status
• Expected cost of financial distress
• Value of financial flexibility
• Dynamic management
– Financing is typically a lumpy process
– Find optimal point where cost of adjusting capital
structure is equal to cost of deviating from target