Reliable Gearing Currently Is All-equity-financed

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What is the goal of the capital structure decision? What is the financial manager trying to do?

The goal is to maximize the overall market value of all the securities issued by the firm. Think of the financial manager as taking all the firm's real assets and selling them to investors as a package of securities. Some financial managers choose the simplest package possible: all-equity financing. Others end up issuing dozens of types of debt and equity securities. The financial manager must try to find the particular combination that maximizes the market value of the firm. If firm value increases, common stockholders will benefit.

Does firm value increase when more debt is used?

Not necessarily. Modigliani and Miller's (MM's) famous debt irrelevance proposition states that firm value can't be increased by changing capital structure. Therefore, the proportions of debt and equity financing don't matter. Financial leverage does increase the expected rate of return to shareholders, but the risk of their shares increases proportionally. MM show that the extra return and extra risk balance out, leaving shareholders no better or worse off.

Of course MM's argument rests on simplifying assumptions. For example, they assume efficient, well-functioning capital markets, and they ignore taxes and costs of financial distress. But even if these assumptions are incorrect in practice, MM's proposition is important. It exposes logical traps that financial managers sometimes fall into, particularly the idea that debt is "cheap financing" because the explicit cost of debt (the interest rate) is less than the cost of equity. Debt has an implicit cost too, because increased borrowing increases financial risk and cost of equity. When both costs are considered, debt is not cheaper than equity. MM show that if there are no corporate income taxes, the firm's weighted-average cost of capital does not depend on the amount of debt financing.

How do corporate income taxes modify MM's leverage irrelevance proposition?

Debt interest is a tax-deductible expense. Thus borrowing creates an interest tax shield, which equals the marginal corporate tax rate Tc times the interest payment rdebt x D. Future interest tax shields are usually valued by discounting at the borrowing rate rdebt. In the special case of permanent debt,

rdebt

Of course interest tax shields are valuable only for companies that are making profits and paying taxes.

If interest tax shields are valuable, why don't all tax-paying firms borrow as much as possible?

The more they borrow, the higher the odds of financial distress. The costs of financial distress can be broken down as follows:

• Direct bankruptcy costs, primarily legal and administrative costs.

• Indirect bankruptcy costs, reflecting the difficulty of managing a company when it is in bankruptcy proceedings.

• Costs of the threat of bankruptcy, such as poor investment decisions resulting from conflicts of interest between debtholders and stockholders.

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Suppose I add interest tax shields and costs of financial distress to MM's leverage irrelevance proposition. What's the result?

The trade-off theory of optimal capital structure. The trade-off theory says that financial managers should increase debt to the point where the value of additional interest tax shields is just offset by additional costs of possible financial distress.

The trade-off theory says that firms with safe, tangible assets and plenty of taxable income should operate at high debt levels. Less profitable firms, or firms with risky, intangible assets, ought to borrow less.

What's the pecking order theory?

The pecking order theory says that firms prefer internal financing (that is, earnings retained and reinvested) over external financing. If external financing is needed, they prefer to issue debt rather than issue new shares. The pecking order theory starts with the observation that managers know more than outside investors about the firm's value and prospects. Therefore, investors find it difficult to value new security issues, particularly issues of common stock. Internal financing avoids this problem. If external financing is necessary, debt is the first choice.

The pecking order theory says that the amount of debt a firm issues will depend on its need for external financing. The theory also suggests that financial managers should try to maintain at least some financial slack, that is, a reserve of ready cash or unused borrowing capacity.

Is financial slack always valuable?

Not if it leads to slack managers. High debt levels (and the threat of financial distress) can create strong incentives for managers to work harder, conserve cash, and avoid negative-NPV investments.

Is there a rule for finding optimal capital structure?

Sorry, there are no simple answers for capital structure decisions. Debt may be better than equity in some cases, worse in others. But there are at least four dimensions for the financial manager to think about.

• Taxes. How valuable are interest tax shields? Is the firm likely to continue paying taxes over the full life of a debt issue? Safe, consistently profitable firms are most likely to stay in a taxpaying position.

• Risk. Financial distress is costly even if the firm survives it. Other things equal, financial distress is more likely for firms with high business risk. That is why risky firms typically issue less debt.

• Asset type. If distress does occur, the costs are generally greatest for firms whose value depends on intangible assets. Such firms generally borrow less than firms with safe, tangible assets.

• Financial slack. How much is enough? More slack makes it easy to finance future investments, but it may weaken incentives for managers. More debt, and therefore less slack, increases the odds that the firm may have to issue stock to finance future investments.

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Key Terms capital structure restructuring MM's proposition I

(debt irrelevance proposition) operating risk, business risk financial leverage financial risk MM's proposition II interest tax shield costs of financial distress trade-off theory pecking order theory financial slack

QUIZ 1. MM's Leverage Irrelevance Proposition. True or false? MM's leverage irrelevance propo sition says that:

a. The value of the firm does not depend on the fraction of debt versus equity financing.

b. As financial leverage increases, the value of the firm increases by just enough to affect the additional financial risk absorbed by equity.

c. The cost of equity increases with financial leverage only when the risk of financial distress is high.

d. If the firm pays no taxes, the weighted-average cost of capital does not depend on the debt ratio.

2. Effects of Leverage. Increasing financial leverage can increase both the cost of debt (rdebt) and the cost of equity (requity). How can the overall cost of capital stay constant? (Assume the firm pays no taxes.)

3. Tax Shields. What is an interest tax shield? How does it increase the "pie" of after-tax income stockholders? Explain. Hint: Construct a simple numerical example showing how financial leverage affects the total cash flow available to debt and equity investors. Be sure to hold pretax operating income constant.

4. Value of Tax Shields. Establishment Industries borrows $800 million at an interest rate of 7.6 percent. It expects to maintain this debt level into the far future. What is the present value of interest tax shields? Establishment will pay tax at an effective rate of 37 percent.

5. Trade-Off Theory. What is the trade-off theory of optimal capital structure? How does it define the optimal debt ratio?

6. Financial Distress. Give three examples of the types of costs incurred by firms in financial distress.

7. Pecking Order Theory. What is the pecking order theory of optimal capital structure? If the theory is correct, what types of firms would you expect to operate at high debt levels?

8. Financial Slack. Why is financial slack valuable? Hint: What does the pecking order theory say about financial slack? Are there circumstances where too much financial slack might actually reduce the market value of the firm?

9. Earnings and Leverage. Suppose that River Cruises, which currently is all-equity financed, issues $250,000 of debt and uses the proceeds to repurchase 25,000 shares. Assume the firm pays no taxes, and that debt finance has no impact on its market value. Rework Table 15.2 to show how earnings per share and share return now vary with operating income.

10. Debt Irrelevance. Suppose an investor is unhappy with River Cruises's decision to borrow $250,000 (see the previous problem). What modifications can she make to her own investment portfolio to offset the effects of the firm's additional borrowing?

11. Leverage and P/E Ratio. Calculate the ratio of price to expected earnings for River Cruises both before and after it borrows the $250,000. Why does the P/E ratio fall after the increase in leverage?

12. Tax Shields. Now suppose that the corporate tax is Tc = .35. Demonstrate that when River Cruises borrows the $250,000, the combined after-tax income of its debtholders and equi-tyholders increases (compared to all-equity financing) by 35 percent of the firm's interest expense regardless of the state of the economy.

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13. Equity Return and Leverage. The common stock and debt of Northern Sludge are valued at $70 million and $30 million, respectively. Investors currently require a 16 percent return on the common stock and an 8 percent return on the debt. If Northern Sludge issues an additional $10 million of common stock and uses this money to retire debt, what happens to the expected return on the stock? Assume that the change in capital structure does not affect the risk of the debt and that there are no taxes.

14. Earnings and Leverage. Reliable Gearing currently is all-equity financed. It has 10,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $200,000 with the proceeds used to buy back stock. The high-debt plan would exchange $400,000 of debt for equity. The debt will pay an interest rate of 10 percent. The firm pays no taxes.

a. What will be the debt-to-equity ratio after each possible restructuring?

b. If earnings before interest and tax (EBIT) will be either $90,000 or $130,000, what will be earnings per share for each financing mix for both possible values of EBIT? If both scenarios are equally likely, what is expected (i.e., average) EPS under each financing mix? Is the high-debt mix preferable?

c. Suppose that EBIT is $100,000. What is EPS under each financing mix? Why are they the same in this particular case?

0 15. Leverage and Risk Premiums. Schuldenfrei A.G. is financed entirely by common stock and has a beta of 1.0. The firm pays no taxes. The stock has a price-earnings multiple of 10 and is priced to offer a 10 percent expected return. The company decides to repurchase half the common stock and substitute an equal value of debt. If the debt yields a risk-free 5 percent, calculate a. the beta of the common stock after the refinancing.

b. the required return and risk premium on the common stock before the refinancing.

c. the required return and risk premium on the common stock after the refinancing.

d. the required return on the debt.

e. the required return on the company (i.e., stock and debt combined) after the refinancing. Assume that the operating profit of the firm is expected to remain constant. Give f. the percentage increase in earnings per share after the refinancing.

g. the new price-earnings multiple. Hint: Has anything happened to the stock price?

16. Leverage and Capital Costs. Hubbard's Pet Foods is financed 80 percent by common stock and 20 percent by bonds. The expected return on the common stock is 12 percent and the rate of interest on the bonds is 6 percent. Assume that the bonds are default-free and that there are no taxes. Now assume that Hubbard's issues more debt and uses the proceeds to retire equity. The new financing mix is 40 percent equity and 60 percent debt. If the debt is still default-free, what happens to the expected rate of return on equity? What happens to the expected return on the package of common stock and bonds?

17. Leverage and Capital Costs. "MM totally ignore the fact that as you borrow more, you have to pay higher rates of interest." Explain carefully whether this is a valid objection.

18. Debt Irrelevance. What's wrong with the following arguments?

a. As the firm borrows more and debt becomes risky, both stock- and bondholders demand higher rates of return. Thus by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.

b. Moderate borrowing doesn't significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won't increase the expected rate of return demanded by stockholders.

Practice Problems

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452 part five Capital Structure and Dividend Policy c. A capital investment opportunity offering a 10 percent internal rate of return is an attractive project if it can be 100 percent debt-financed at an 8 percent interest rate.

d. The more debt the firm issues, the higher the interest rate it must pay. That is one important reason why firms should operate at conservative debt levels.

Leverage and Capital Costs. A firm currently has a debt-equity ratio of 1/2. The debt, which is virtually riskless, pays an interest rate of 6 percent. The expected rate of return on the equity is 12 percent. What would happen to the expected rate of return on equity if the firm reduced its debt-equity ratio to 1/3? Assume the firm pays no taxes. Leverage and Capital Costs. If an increase in the debt-equity ratio makes both debt and equity more risky, how can the cost of capital remain unchanged?

Tax Shields. Look back to Table 2.2 where we provided a summary 1998 income statement for PepsiCo, Inc. If the tax rate is 35 percent, what is PepsiCo's annual interest tax shield? What is the present value of the annual tax shield if the company plans to maintain its current debt level indefinitely? Assume a discount rate of 8 percent.

WACC. Here is Establishment Industries's market-value balance sheet (figures in millions):

Net working capital $ 550 Debt $ 800 Long-term assets $2,150 Equity $1,900 Value of firm_$2,700_$2,700

The debt is yielding 7.6 percent and the cost of equity is 14 percent. The tax rate is 37 percent. Investors expect this level of debt to be permanent.

a. What is Establishment's WACC?

b. Write out a market-value balance sheet assuming Establishment has no debt. Use your answer to problem 4.

23. Tax Shields and WACC. Here are book- and market-value balance sheets of the United Fry-pan Company:

BOOK-VALUE BALANCE SHEET

Net working capital

$ 20

Debt

$ 40

Long-term assets

80

Equity

60

$100

$100

MARKET-VALUE BALANCE SHEET

Net working capital

$ 20

Debt

$ 40

Long-term assets

140

Equity

120

$160

$160

Assume that MM's theory holds except for taxes. There is no growth and the $40 of debt is expected to be permanent. Assume a 35 percent corporate tax rate.

a. How much of the firm's value is accounted for by the debt-generated tax shield?

b. What is United Frypan's after-tax weighted average cost of capital (WACC)?

c. Now suppose that Congress passes a law that eliminates the deductibility of interest for tax purposes after a grace period of 5 years. What will be the new value of the firm, other things equal? Assume an 8 percent borrowing rate.

Bankruptcy. What are the drawbacks of operating a firm that is close to bankruptcy? Give some examples.

Costs of Financial Distress. The Salad Oil Storage Company (SOS) has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet. Explain

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a. why SOS stockholders could lose by investing in a positive-NPV project financed by an equity issue.

b. why SOS stockholders could gain by investing in a highly risky, negative-NPV project.

26. Financial Distress. Explain how financial distress can lead to conflicts of interest between debt and equity investors. Then explain how these conflicts can lead to costs of financial distress.

27. Costs of Financial Distress. For which of the following firms would you expect the costs of financial distress to be highest? Explain briefly.

a. A computer software company which depends on skilled programmers to produce new products.

b. A shipping company that operates a fleet of modern oil tankers.

28. Trade-Off Theory. Smoke and Mirrors currently has EBIT of $25,000 and is all-equity financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 35 percent of taxable income. The discount rate for the firm's projects is 10 percent.

a. What is the market value of the firm?

b. Now assume the firm issues $50,000 of debt paying interest of 6 percent per year, using the proceeds to retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus equity)?

c. Recompute your answer to (b) under the following assumptions. The debt issue raises the possibility of bankruptcy. The firm has a 30 percent chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankruptcy costs of $200,000. The discount rate is 10 percent. Should the firm issue the debt?

29. Pecking Order Theory. Alpha Corp. and Beta Corp. both produce turbo encabulators. Both companies' assets and operations are growing at the same rate and their annual capital expenditures are about the same. However, Alpha Corp. is the more efficient producer and is consistently more profitable. According to the pecking order theory, which company should have the higher debt ratio? Explain.

30. Financial Slack. Look back to the Sealed Air example in the box in Section 15.4. What was the value of financial slack to Sealed Air before its restructuring? What does the success of the restructuring say about optimal capital structure? Would you recommend that all firms restructure as Sealed Air did?

Challenge Problems

31. Costs of Financial Distress. Let's go back to the Double-R Nutting Company. Suppose that Double-R's bonds have a face value of $50. Its current market-value balance sheet is

Assets

Liabilities and Equity

Net working capital $ 20 Fixed assets 10

Total assets $ 30

Bonds outstanding $25

Common stock 5

Total liabilities and shareholders' equity $30

Who would gain or lose from the following maneuvers?

a. Double-R pays a $10 cash dividend.

b. Double-R halts operations, sells its fixed assets for $6, and converts net working capital into $20 cash. It invests its $26 in Treasury bills.

c. Double-R encounters an investment opportunity requiring a $10 initial investment with NPV = $0. It borrows $10 to finance the project by issuing more bonds with the same security, seniority, and so on, as the existing bonds.

d. Double-R finances the investment opportunity in part (c) by issuing more common stock.

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32. Trade-Off Theory. Ronald Masulis12 has analyzed the stock price impact of exchange offers of debt for equity or vice versa. In an exchange offer, the firm offers to trade freshly issued securities for seasoned securities in the hands of investors. Thus a firm that wanted to move to a higher debt ratio could offer to trade new debt for outstanding shares. A firm that wanted to move to a more conservative capital structure could offer to trade new shares for outstanding debt securities. Masulis found that debt-for-equity exchanges were good news (stock price increased on announcement) and equity-for-debt exchanges were bad news.

a. Are these results consistent with the trade-off theory of capital structure?

b. Are the results consistent with the evidence that investors regard announcements of (i) stock issues as bad news, (ii) stock repurchases as good news, and (iii) debt issues as no news, or at most trifling disappointments?

33. Pecking Order Theory. Construct a simple example to show that a firm's existing stockholders gain if it can sell overpriced stock to new investors and invest the cash in a zero-NPV project. Who loses from these actions? If investors are aware that managers are likely to issue stock when it is overpriced, what will happen to the stock price when the issue is announced?

34. Pecking Order Theory. When companies announce an issue of common stock, the share price typically falls. When they announce an issue of debt, there is typically only a negligible change in the stock price. Can you explain why?

35. Taxes. MM's proposition I suggests that in the absence of taxes it makes no difference whether the firm borrows on behalf of its shareholders or whether they borrow directly. However, if there are corporate taxes, this is no longer the case. Construct a simple example to show that with taxes it is better for the firm to borrow than for the shareholders to do so.

36. Taxes. MM's proposition I, when modified to recognize corporate taxes, suggests that there is a tax advantage to firm borrowing. If there is a tax advantage to firm borrowing, there is also a tax disadvantage to firm lending. Explain why.

15.1 Price per share will stay at $10, so with $350,000, River Cruises can repurchase 35,000 shares, leaving 65,000 outstanding. The remaining value of equity will be $650,000. Overall firm value stays at $1 million. Shareholders' wealth is unchanged: they start with shares worth $1 million, receive $350,000, and retain shares worth $650,000.

Solutions to

Self-Test

Questions

Number of shares Price per share Market value of shares Market value of debt

25,000 $10

$250,000 $750,000

State of the Economy

Slump Normal Boom

Operating income, dollars Interest, dollars Equity earnings, dollars Earnings per share, dollars Return on shares

75,000 125,000 175,000

75,000 75,000 75,000

0 50,000 100,000

12 R. W. Masulis, "The Effects of Capital Structure Change on Security Prices: A Study of Exchange Offers," Journal of Financial Economics 8 (June 1980), pp. 139-177, and "The Impact of Capital Structure Change on Firm Value," Journal of Finance 38 (March 1983), pp. 107-126.

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chapter 15 The Capital Structure Decision 455

Every change of $50,000 in operating income leads to a change in the return to equity-holders of 20 percent. This is double the swing in equity returns when debt was only $500,000.

b. The stockholder should lend out $3 for every $1 invested in River Cruises's stock. For example, he could buy one share for $10 and then lend $30. The payoffs are:

15.3 Business risk is unaffected by capital structure. As the financing mix changes, whatever equity is outstanding must absorb the fixed business risk of the firm. The less equity, the more risk absorbed per share. Therefore, as capital structure changes, rassets is held fixed while requity adjusts.

15.4 Exxon's borrowing reduced taxable profits by $100 million. With a tax rate of 35 percent, tax was reduced by .35 x $100 = $35 million. If the borrowing is permanent, Exxon will save this amount of tax each year. The present value of the tax saving would be $35/.08 = $437.5 million.

15.5 In bankruptcy bondholders will receive $2 million less. This lowers the expected cash flow from the bond and reduces its present value. Therefore, the bonds will be priced lower and must offer a higher interest rate. This higher rate is paid by the firm today. It comes out of stockholders' income. Thus common stock value falls.

15.6 The conflicts are costly because they lead to poor investment decisions. The more debt the firm has today, the greater the chance of poor decisions in the future. Investors foresee this possibility and reduce today's market value of the firm.

15.7 The biotech company. Its assets are all intangible. If bankruptcy threatens and the best scientists accept job offers from other firms, there may not be much value remaining for the biotech company's debt and equity investors. On the other hand, bankruptcy would have little or no effect on the value of 50 producing oil wells, and of the oil reserves still in the ground.

15.8 The electric utility has the most stable cash flow. It also has the highest reliance on tangible assets that would not be impaired by a bankruptcy. It should have the highest debt ratio. The software firm has the least dependence on tangible assets and the most on assets that have value only if the firm continues as an ongoing concern. It probably also has the most unpredictable cash flows. It should have the lowest debt ratio.

State of the Economy

Slump Normal Boom

Earnings on one share Plus interest at 10% Net earnings

Return on $40 investment

In March 2001 the management team of Londonderry Air (LA) met to discuss a proposal to purchase five shorthaul aircraft at a total cost of $25 million. There was general enthusiasm for the investment and the new aircraft were expected to generate an annual cash flow of $4 million for 20 years.

but Ed Johnson, the chief financial officer, pointed out that the company needed at least $10 million in cash to meet normal outflow and as a contingency reserve. This meant that there would be a cash deficiency of $15 million, which the firm would need to cover either by the sale of common stock or by additional borrowing. While admitting that the arguments were finely balanced, Johnson recommended an issue of stock. He pointed out that the

The focus of the meeting was on how to finance the purchase. LA had $20 million in cash and marketable securities (see table),

456 part five Capital Structure and Dividend Policy

Summary financial statements for Londonderry Air, 2000 (figures are book values, in millions of dollars)

Balance Sheet

Bank debt

$ 50

Cash

$ 20

Other current liabilities

20

Other current assets

20

10% bond, due 20201

100

Fixed assets

250

Stockholders' equity2,3

120

Total liabilities

$290

Total assets

$290

Income Statement

Gross profit

57.5

Depreciation

20.0

Interest

7.5

Pretax profit

30.0

Tax

10.5

Net profit

19.5

Dividend

6.5

1. The yield to maturity on LA debt currently is 5 percent.

2. LA has 10 million shares outstanding, with a market price of $10 a share.

3. LA's equity beta is estimated at 1.25, the market risk premium is 8 percent, and the Treasury bill rate is 4 percent.

Notes:

1. The yield to maturity on LA debt currently is 5 percent.

2. LA has 10 million shares outstanding, with a market price of $10 a share.

3. LA's equity beta is estimated at 1.25, the market risk premium is 8 percent, and the Treasury bill rate is 4 percent.

airline industry was subject to wide swings in profits and the firm should be careful to avoid the risk of excessive borrowing. He estimated that in market value terms the long-term debt ratio was about 62 percent and that a further debt issue would raise the ratio to 64 percent.

Johnson's only doubt about making a stock issue was that investors might jump to the conclusion that management believed the stock was overpriced, in which case the announcement might prompt an unjustified selloff by investors. He stressed therefore that the company needed to explain carefully the reasons for the issue. Also, he suggested that demand for the issue would be enhanced if at the same time LA increased its dividend payment. This would provide a tangible indication of management's confidence in the future.

These arguments cut little ice with LA's chief executive. "Ed," she said, "I know that you're the expert on all this, but everything you say flies in the face of common sense. Why should we want to sell more equity when our stock has fallen over the past year by nearly a fifth? Our stock is currently offering a dividend yield of 6.5 percent, which makes equity an expensive source of capital. Increasing the dividend would simply make it more expensive. What's more, I don't see the point of paying out more money to the stockholders at the same time that we are asking them for cash. If we hike the dividend, we will need to increase the amount of the stock issue; so we will just be paying the higher dividend out of the shareholders' own pockets. You're also ignoring the question of dilution. Our equity currently has a book value of $12 a share; it's not playing fair by our existing shareholders if we now issue stock for around $10 a share.

"Look at the alternative. We can borrow today at 5 percent. We get a tax break on the interest, so the after-tax cost of borrowing is .65 x 5 = 3.25 percent. That's about half the cost of equity. We expect to earn a return of 15 percent on these new aircraft. If we can raise money at 3.25 percent and invest it at 15 percent, that's a good deal in my book.

"You finance guys are always talking about risk, but as long as we don't go bankrupt, borrowing doesn't add any risk at all. In any case my calculations show that the debt ratio is only 45 percent, which doesn't sound excessive to me.

"Ed, I don't want to push my views on this—after all, you're the expert. We don't need to make a firm recommendation to the board until next month. In the meantime, why don't you get one of your new business graduates to look at the whole issue of how we should finance the deal and what return we need to earn on these planes?"

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