Capital Structure II: Market Imperfections - Notes

Capital Structure II: Market Imperfections

• MM Propositions Recap:
  • In a perfect and complete world, capital structure changes do not affect:
    • Firm value and WACC (WACC = Ru).
    • Cost of equity increases with financial leverage.
    • Home-made leverage.
  • Firms cannot do anything investors can't do themselves re: capital structure and returns to equity.
  • No capital structure is considered optimal.
  • Key assumptions:
    • No taxes.
    • No risk of bankruptcy.
    • No agency problems.
    • No asymmetric information.
    • Investors can borrow at the same rate as corporations.

Outline

• What if markets are not perfect?
  • Valuation by parts.
  • Relax assumption 1: Corporate tax.
    • Interest tax shield (Market value of balance sheet).
  • Relax assumption 2: Bankruptcy costs.
  • Relax assumption 3: Agency problems.
  • If capital structure changes, what happens to the cost of equity?
    • Equity beta of levered firm contains two parts.
      • Unlevered asset beta.
      • "De-lever" vs. "Re-lever."
  • Required reading: RWJordan Chapter 15-16.

Valuation by Parts

• Objectives:
  • Examine the costs and benefits of leverage in an imperfect world.
  • Understand how leverage influences value.
• Approach: "Valuation by parts."
  • Value of levered firm = Value of unlevered firm + Net value added by debt.
• Note:
  • Value of unlevered firm is obtained by discounting FCFs (and TV) at the unlevered firm’s cost of capital, Ru.
  • Value added by debt is not the same as the value of debt.

Why Valuation by Parts?

• Traditionally, FCFs (and terminal value) are discounted at the levered firm’s WACC to get firm value, where Re is the levered firm’s cost of equity.
  • WACC = \frac{E}{V} \times Re + \frac{D}{V} \times Rd \times (1 - T)
• This direct method is difficult to handle when leverage changes:
  • FCF does not change with leverage.
  • But WACC does.
  • It is difficult to figure out WACC after the change in leverage.
• Valuation by parts makes it easier to see the change in value due to the change in leverage.

Market Imperfection I: Corporate Taxes

• Interest is a tax-deductible expense, while dividends are not.
  • With taxes, there is a relative advantage to using debt (or a disadvantage to using equity).
• How to value this:
  • Interest expense = R_dD
  • Interest tax shield = RdD \times Tc
  • Suppose interest tax shield is a perpetuity, then:
    • Value added by debt = T_c D
• Example: A firm has a perpetual debt of $1,000, and the tax rate is 35%; then, the PV of the interest tax shield is $1,000 × 35% = $350.

M&M with Corporate Taxes

• Let V(L) and V(U) denote the values of the levered and unlevered firms, respectively. Then:
  • V(L) = V(U) + T_c D
  • Re = Ru + \frac{D}{E} (Ru - Rd)(1 - T_c)
  • WACC = \frac{E}{V} \times Re + \frac{D}{V} \times Rd \times (1 - T_c)

Example I: MM with Taxes

• Example: Dividend Airlines expects to generate an EBIT of $153.85 in perpetuity.
  • Tax rate is 35%. Unlevered cost of capital is 20%.
• Questions:
  • What is the firm value if it takes on $200 of debt at 10% interest? (Ignore depreciation, NWC, capex).
  • What is equity value?
  • What’s the cost of equity?
  • What’s WACC?

Answer Key to Example I

• Firm value:
  • Value of unlevered firm = PV of FCFs discounted at Ru = 20%.
  • FCF = $100 (=EBIT*(1-T)).
  • So, value of unlevered firm = $500.
  • Value added by debt = T_c D = $70.
  • So, total firm value = $500 + $70 = $570.
• Equity value:
  • Using sequential valuation…
  • Equity value = $570 - $200 = $370.
• R_e = 20% + (\frac{200}{370}) \times (20% - 10%) \times (1 - 0.35) = 23.51%
• WACC = (\frac{370}{570}) \times 23.51% + (\frac{200}{570}) \times 10% \times 0.65 = 17.54%

Re, \betae, and Corporate Taxes

• Corporate taxes reduce the financial risk of the firm.
• We can also express this in terms of \betas:
  • Ri = Rf + \betai (Rm – R_f)
  • Re = Ru + \frac{D}{E}(Ru - Rd)(1 - T_c)
  • \betae = \betau + \frac{D}{E}(\betau - \betad)(1 - T_c)
• With corporate taxes, as the firm’s capital structure changes, both cost of equity (R_e) and WACC will change.
  • Note the crucial difference: Without taxes, in the MM world, WACC always remained the same.

Example II

• A firm has a debt-to-equity ratio of 2/3. Its cost of equity is 15.2%, cost of debt is 4%, and the tax rate is 35%. Assume that the risk-free rate is 4%, and the market risk premium is 8%.
• Suppose the firm repurchases stock and finances the repurchase with debt, causing its debt-to-equity ratio to change to 3/2:
  • Compute the firm’s new equity beta and new cost of equity?
  • What is the firm’s WACC before and after the change in capital structure?

Solution Steps

• First, “de-lever” to obtain unlevered asset beta using the current capital structure.
  • If betas are not given, derive using CAPM.
• Next, lever it up to the target leverage ratio to determine the new equity beta.
• Calculate the new expected return on equity.
  • Using CAPM.
• Then, calculate the new WACC under the target leverage ratio.

Answer Key to Example II (1)

• To compute the new \betae, we first have to solve for the \betau using the equation:
  • \betae = \betau + (\frac{D}{E}) \times (\betau - \betad)(1 - T_c)
  • First, compute old \betae and \betad using CAPM:
    • \beta_e =
    • \beta_d =
  • Solve for \beta_u
    • \beta_u =
  • Solve for new \beta_e =
  • (CAPM) New R_e = 4% + 1.929 × 8% = 19.43%

Answer Key to Example II (1)

• To compute the new \betae, we first have to solve for the \betau using the equation:
  • \betae = \betau + (\frac{D}{E}) \times (\betau - \betad)(1 - T_c)
  • We can compute \betae and \betad using CAPM:
    • 15.2% = 4% + \betae × 8% ⇒ \betae = 1.4
    • 4% = 4% + \betad × 8% ⇒ \betad= 0
  • Substituting \betae and \betae in the above equation:
    • 1. 4 = \betau + (2/3)( \betau – 0)(1-0.35)
    • Solve for \beta_u (some algebra involved):
      • \beta_u = 0.977
  • New \beta_e = 0.977 + (3/2)(0.977-0)0.65 = 1.929
  • (CAPM) New R_e = 4% + 1.929×8% = 19.43%

Answer Key to Example II (2)

• Computing old WACC:
  • Old D/E ratio = 2/3
    • So D/V = and E/V =
  • So old WACC =
• Computing new WACC:
  • Note that the weights and Re have changed
  • New D/E ratio = 3/2
    • So D/V = , E/V =
  • So new WACC =

Answer Key to Example II (2)

• Computing old WACC:
  • D/E ratio = 2/3
    • So D/V = 2/5 = 0.4 and E/V = 3/5 = 0.6
  • So old WACC = (0.4×4%×0.65) + (0.6×15.2%) = 10.16%
• Computing new WACC:
  • Note that the weights and Re have changed
  • D/E ratio = 3/2: So D/V = 0.6, E/V = 0.4
  • So new WACC = 0.6×4%×0.65 + 0.4×19.43% = 9.33%

Summary: MM + Taxes

• In the MM world with taxes, as leverage increases:
  • Cost of equity, Re , increases, but the increase is less than in the perfect MM world.
  • WACC decreases, so firm value increases.
    • The reason is that debt generates interest tax shield.
    • Key assumption: No bankruptcy risk.
    • Therefore, WACC = Ru only if the firm has zero debt.
    • So, the optimal capital structure is to have 100% debt.
• Does MM theory combined with taxes predict the capital structure of real-life firms?
  • No!

Market Imperfection II: Bankruptcy Costs

• Debt can put pressure on the firm’s finances during bad times (“financial distress”).
  • Because interest and principal payments (unlike dividend payments) are legal obligations.
• Bankruptcy: Legal transfer of ownership of a firm’s assets to debtholders in the event of a default.
  • Think of it as an extreme form of financial distress.
• Two forms of bankruptcy in the US:
  • Chapter 11 (reorganization): Firm gets a temporary respite from creditors so that it can reorganize.
  • Chapter 7 (liquidation).

Bankruptcy Costs

• There are both direct and indirect costs to bankruptcy (ultimately, borne by shareholders).
• Direct costs: Legal and administrative.
  • Although large in absolute terms, usually not very big in proportion to total value.
    • Only 1% of market value 7 years prior (Warner (1977)).
    • In Macy’s 1992 Chapter 11 bankruptcy, at least $100 million (2 to 3 percent of Macy’s value).
    • Real Example: Orange County.
• Indirect costs: Due to disruption of normal activities.
  • Firms’ ability to sell claims to customers is affected.
    • e.g., customers of NWA, United, Delta, etc., may stop attaching value to their frequent flyer miles.
  • Firm’s suppliers may not invest in firm-specific inputs; may stop extending favorable financing terms.
    • e.g., GM would be wary of investing in Delphi.
  • Firm could lose precious human capital.

Bankruptcy Costs and WACC

• In the perfect MM world, as leverage increases:
  • Only Re increases; Rd is unchanged.
  • Overall, WACC and firm value are unchanged.
• What happens when bankruptcy costs are the only imperfection introduced into the MM world?
  • As leverage increases:
    • Rd increases due to higher expected bankruptcy costs.
    • Re also increases (just as in the MM world).
    • Overall, WACC also increases, and firm value falls.
  • Bankruptcy costs cause value added by debt to be negative.

Expected Bankruptcy Costs

• Expected bankruptcy cost = Cost of bankruptcy × Prob. of bankruptcy
  • Example: If the estimated bankruptcy cost is $500 (mil), and the probability of bankruptcy is 5%, then the expected bankruptcy cost is $500 × 5% = $25 (mil).
• What firm characteristics influence expected bankruptcy costs?
  • Business risk of the firm.
  • Proportion of intangibles in total assets:
    • Tangible assets such as land, machinery, etc., can be liquidated or redeployed easily.
    • Intangible assets such as human capital, brand value, R&D capabilities, are lost in the event of bankruptcy.
    • So, a high proportion of intangibles ⇒ high expected bankruptcy costs.

Corporate Taxes and Bankruptcy Costs

• Corporate taxes and bankruptcy costs impact firm value differently.
  • Bankruptcy costs lower firm value.
  • Interest tax shield increases firm value.
• Putting together, we have the value added by debt:
  • V(L) = V(U) + T_cD - PV \text{ of expected bankruptcy costs}

Optimal Leverage (with bankruptcy costs and taxes)

• In a world with both bankruptcy costs and taxes, as the firm adds debt:
  • Firm value increases if PV of interest tax shield exceeds PV of expected bankruptcy costs.
  • Firm value decreases if PV of the interest tax shield is less than PV of expected bankruptcy costs.
• Optimal leverage is that leverage beyond which costs of debt exceed its benefits.

M&M Prop 1 with Corporate Taxes and Bankruptcy Costs

The point at which the lowest WACC is achieved is the optimal D/E.

M&M Prop 2 with Taxes and Bankruptcy Costs

Increasing D/E decreases WACC because the tax advantage outweighs the increase in the probability of bankruptcy. But at some point, the probability of bankruptcy increases enough to outweigh the tax benefits.

Market Imperfection III: Agency Problems

• Apart from providing an interest tax shield and increasing bankruptcy costs, debt also has an impact on the various “agency problems” (or conflicts of interest) within the firm.
• Why do agency problems arise?
  • Shareholders are protected by limited liability, so they may take undue advantage of debtholders.
  • Managers run the firm on behalf of shareholders, but they may misuse corporate resources and cash flows.
• We focus on two main “agency problems”:
  • Conflicts between debt holders and equity holders.
  • Conflicts between managers and equity holders.

Agency Problems: Shareholders vs. Debtholders

• Shareholders are protected by limited liability.
  • i.e., even if a firm defaults on debt, debtholders cannot touch the personal assets of shareholders.
• Limited liability protection can cause shareholders of levered firms to take on excessively risky projects.
  • If the project succeeds, shareholders get the upside.
  • If the project fails, debtholders bear most of the burden.
• This is known as “risk shifting”.
  • Extreme example:
    • When FedEx was in deep trouble, the founder reportedly gambled with $20,000 of corporate funds in Las Vegas.

Example III: Risk Shifting

• A firm has two project choices: ‘A’ and ‘B’.
  • ‘A’ yields a CF of $200 in a “boom” and $0 in a “recession”.
  • ‘B’ yields a CF of $120 in a “boom” and $110 in a “recession”.
  • Both “boom” and “recession” are equally likely.
• Questions:
  • Which project will the firm choose if it has zero debt?
  • Instead, suppose the firm is financed with debt on which interest and principal repayments total $50? Which project will shareholders pick, and why?

Answer Key to Example III

• If the firm has zero debt:
  • Value of project A= 0.5×0 + 0.5×200 = $100
  • Value of project B = 0.5×110 + 0.5×120 = $115
  • So, the firm will pick project B
• Instead, if it has debt, payoffs look as under:
  • Shareholders will now pick the riskier Project A, even though it is less valuable than Project B.
  • Shareholders are benefiting at the expense of debtholders.

Conflict Between Shareholders and Debtholders

• We saw that risk-shifting destroys firm value.
  • As debt aggravates the agency problems between shareholders and debtholders, debt can destroy firm value.
• But how serious is this problem? --- It depends on firm characteristics, mainly growth prospects.
  • Risk shifting is a serious concern with high-growth firms and risky firms, e.g., high-tech businesses.
  • Less serious problem with large established firms.

FedEx Example

Fred Smith, FedEx Founder and CEO, once gambled with the company’s last $5,000 in Las Vegas on blackjack to keep the company alive. Had Smith's bet gone awry, FedEx wouldn't have been able to foot a $24,000 fuel bill.

Conflict Between Shareholders and Managers

• Managers can misuse “excess” FCF by:
  • Investing in negative NPV pet projects (“empire building”), consuming excessive perks, etc.
  • Excess FCF is the portion of FCF left over after dividend and debt payments have been made.
• Debt mitigates (i.e., reduces) agency problems between shareholders and managers.
  • Lenders (banks, etc.) act as monitors by serving on a firm’s board of directors, etc.
  • Also, by requiring frequent payments, debt minimizes the amount of excess FCF that can be wasted.

Impact of Agency Problems

• As a firm increases debt,
  • Severity of the agency problem between shareholders and debt-holders:
    • Increases (More risk-shifting).
    • This decreases value added by debt and firm value.
  • Severity of the agency problem between shareholders and managers:
    • Decreases (Less free cash flows).
    • This increases value added by debt and firm value.

Combined Impact of All Imperfections

• When you incorporate corporate taxes, bankruptcy costs, and agency problems into the MM world, It is more difficult to calculate these new costs and benefits
  • V(L) = V(U) + \text{value added by debt}
  • \text{value added by debt} = T_cD - PV \text{ (expected bankruptcy costs)}+ \text{value gain from improved monitoring} - \text{value loss due to excess risk taking}

Combined Impact of All Imperfections

• Main benefits of debt:
  • Tax benefit in the form of interest tax shield.
  • Monitoring benefit of debt which mitigates agency problems between shareholders and managers.
• Main costs of debt:
  • Bankruptcy costs.
  • Risk-shifting, due to agency problems between shareholders and debtholders.

Trade-off Theory of Optimal Leverage

• So, in the most realistic case of M&M, considering both taxes and bankruptcy, firms should strike a balance between the tax benefits of debt and the bankruptcy costs of debt when determining capital structure.
• Do firms actually do this?
  • Some evidence suggests Yes: Industries with higher bankruptcy costs tend to have lower debt.
  • Some evidence suggests No: Firms don’t usually make large shifts in capital structure due to taxes, and the most profitable companies tend to borrow the least.
• Is there room for another theory?

Pecking Order Theory

• Myers and Majluf (1984): With asymmetric information in the capital market, investors cannot correctly value a company.
  • E.g., CFO has more information about his company than investors do.
    • Stock prices change when a company makes announcements.
    • Insider trading can produce huge gains.
• A “pecking order” of capital sources
  • First use internal funds
  • Then issue debt
  • Issue equity as a last resort
• The pecking-order theory is at odds with the tradeoff theory:
  • There is no target D/E ratio
  • Profitable firms use less debt
  • Companies like financial flexibility
• How does this pecking order arise?

The Advantages of Internal Funds

• Internal funds are the dominant source of financing for capital needs.
• Internal funds are readily available to the financial manager (“Cheaper”).
  • No public offering or private placement needed.
  • No transaction costs.
  • No questions from outside investors.
• If a financial manager thinks the firm has good investment opportunities, this seems like a likely source of capital.

Asymmetric Information Leads to Firm Actions

• Two firms: Hoosiers Inc & Boilermakers Co
• Public information and market expectations are identical for both firms; Both stocks currently trade at $100
  • Based on private information known by the CFO, one firm is actually worth $80
  • The other CFO knows his firm is actually worth $120
• Both firms need more capital
  • Can raise funds using either equity or debt
• Each firm makes an announcement
  • Hoosiers Inc is beginning a $1 million public debt offering
  • Boilermakers Co is planning to issue $1 million in new equity at $100 per share
• Which company is actually worth $80 per share? Which one is worth $120 per share?
• The market incorporates this same information… what would the market reaction be?

CFOs Know This Market Reaction Will Occur

• CFOs have thought a step ahead
  • Know that issuing stock will cause their stock to fall
• What do the CFOs do?
  • Both Hoosiers and Boilermakers issue debt for $1 million
• Market reaction?
  • No new information… no price reaction
• Implications: No firm would want to issue equity instead of debt

Our Pecking Order

• It is suboptimal for any firm to issue equity if it can issue debt because either:
  • Equity is underpriced and debt is cheaper
  • Equity is overpriced and issuing equity will signal the market about this mispricing… the stock price will fall to fair value
• So, debt is above equity in the pecking order of firm financing
• Evidence in the real world?

Summary: Pecking Order

The CFO starts with the most desirable funding sources, and then goes down the following list:

1. First, use internal funds
2. When internal funds run out, issue debt
3. When the firm can’t borrow any more due to default risk, issue equity