Summary Advanced Corporate Finance and Governance
Lecture 2a: Relevance and irrelevance of capital structure
§ Introduction
- Capital structure: the mix of securities and financing sources used to finance real
investment by corporations.
® The goal: to make sure that the available money in the world goes to right
companies that improve our quality of life, ensure economic growth and innovation.
- What determines firm’s financing decisions?
1. Debt financing
ü Examples: loan (bank), issuing a bond
ü Cash flow: If a company borrows money, it pays interest over this.
ü Do debtholders have a right to these cash flows? Yes, if the company doesn’t
provide these interest payments, then bankruptcy is a potential outcome.
ü Voting power? No, they do not get to vote on the decisions made by a firm.
2. Equity financing
ü Examples: common share
ü Cash flow: dividends, capital gains that can be realised
ü Do shareholders have a right to these cash flows? No. In a year where the
company doesn’t pay dividends and the stock price doesn’t go up, there is
nothing you can do as shareholder (risk that you take).
ü Voting power? Yes, the shareholder buys a share of ownership.
- Is a firm’s value affected by its capital structure?
Value firm = Discounted value of future cash flows
® Optimal capital structure: minimize the weighted average cost of capital.
Re = expected return equity holders
Rd = expected return debt holders
® Interest rate on debt (rd) generally lower than required return on shares (re).
Shareholders take a higher risk, so they demand a higher return. So could we minimize
WACC by finance only with debt? This is answered by Modigliani and Miller who proof
that financing doesn’t matter in perfect capital markets.
§ Capital structure theories
- The leading theories of capital structure:
1. Capital-Structure Irrelevance: the firm value and real investment decisions are
independent of financing. The choice between debt and equity is not totally
unimportant, but its effects on real decisions are second- or third-order.
2. Static trade-off theory: firms choose target debt ratios by trading off the tax
benefits of debt against the costs of bankruptcy and financial distress.
, 3. Agency theory: financing decisions have first-order effects because they change
managers’ incentives and their investment and operating decisions. Agency costs
drive financing – or at least they explain the effects of financing decisions.
4. Pecking-order theory: a firm turns first to the financing sources where differences
in information matter least.
§ 1. The Modigliani–Miller value-irrelevance propositions
- Modigliani and Miller’s proof that financing doesn’t matter in perfect capital markets.
- Example that explains MM:
A firm currently has no debt in its capital structure (all equity firm). The firm is
considering issuing debt to buy back some of its equity.
• The firm’s assets are $8000.
• There are 400 shares of the all-equity firm.
• The proposed debt issue is $4000 (interest rate 10%).
• There are no taxes.
• Return on assets (ROA) are 5%, 15%, or 25%.
Blue line: firm without debt (unlevered firm)
Red line: firm with debt (levered firm)
The line of the levered firm is steeper. This means that investing in this firm is
riskier. You cannot see which firm is better, because we don’t know what will
happen with the value of the assets.
, ® Which strategy is better?
The payoffs of strategy A en B are exactly the same, so the value is the same! That is
the outcome of MM: firm value does not depend on capital structure, because you
have homemade leverage (if a firm does not borrow, you have to borrow yourself).
- MM’s Proposition 1
The value of an asset remains the same, regardless of how the net operating cash
flows generated by the asset are divided between different classes of investors.
PIE THEORY: You cannot change the size of a pie by cutting it into different sized slices
(i) V is a constant, regardless of the proportions of D and E
(ii) Each firm’s cost of capital is a constant, regardless of the debt ratio D/V
® How could this be? We saw before that cost of debt is generally lower than
required return on shares. How can the value of the firm be independent of leverage?
This is explained by M&M Proposition 2.
- MM’ Proposition 2
Solving the equation of cost of capital for the cost of equity gives: rE =rA + (rA −rD)D/E.
rA or r0 = cost of equity of an unlevered firm
“The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm
plus a financial risk premium, which depends on the degree of financial leverage
(more debt means that it is riskier to invest, so shareholders demand a higher return)”
® If you change capital structure, the WACC will not change.
- M&Ms assumptions:
(1) Individuals borrow at the same rate as corporations
® Not realistic: it is cheaper for companies to borrow than for individuals.
(2) Perfect capital market (no information asymmetry or transaction costs)
® Transaction costs may matter: what is more expensive issuing bonds or issuing
shares? It turns out that on average issuing shares is quite expensive (costs are
about 7% compared to bonds of 2%) in terms of transaction costs.
, (3) No taxes
(4) No costs for financial distress
(5) Fixed investment policy: the investments you are doing do not depend on how
they are financed.
- The MM propositions are a starting point. The propositions say that financing does not
affect value except for specifically identified costs or imperfections. As Merton Miller
noted, “showing what doesn’t matter can also show, by implication, what does”.
Lecture 2b: capital structure, static trade-off theory
§ Changing MMs assumptions: Taxes
- In a classical tax system leverage will increase a firm’s value because interest on debt
is a tax deductible expense resulting in an increase in the after-tax net cash flows.
® Dividends are not tax deductable.
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)
First: EBIT = EBITDA – Depreciation & Amortization
Second: EBT = EBIT - Interest
Third: NET EARNINGS = EBT – Taxes
With the net earnings you can pay out dividends or you can retain your earnings.
Because you pay interest before paying taxes, there is a clear advantage of paying interests
- rather
MM than dividends.
Proposition I with taxes:
Value of a levered firm is equal to the value of an unlevered firm of the same risk class
plus the present value of the tax saving
- Personal taxes might matter: if you are an investor and pay very high taxes on your
dividends, then this affects the required return you want to see.
- Conclusion: from a corporate tax perspective debt had a clear advantage. From a
personal tax perspective equity has a slight advantage. But overall debt is still more
beneficial than equity, so the prediction is that a lot of firms use debt to reduce the
taxes they have to pay.
§ Changing MMs assumptions: Costs for financial distress
- You don’t want to have too much debt, because the chance of bankruptcy reduces
firm value.
- Direct and indirect costs of financial distress (or bankruptcy).
a) Direct costs: Lawyer, fire sales (its hard to get a fair price when people know you
are in distress), etc.
b) Indirect costs (for most firms these costs matter more): losing sales already, time
people have to spend to avoid bankruptcy, suppliers who stop deliveries,
employees who not want to work for you firm.
- Average costs of of financial distress: 10-20% firm value.
- The higher the leverage you have, the higher the chance of bankruptcy:
Lecture 2a: Relevance and irrelevance of capital structure
§ Introduction
- Capital structure: the mix of securities and financing sources used to finance real
investment by corporations.
® The goal: to make sure that the available money in the world goes to right
companies that improve our quality of life, ensure economic growth and innovation.
- What determines firm’s financing decisions?
1. Debt financing
ü Examples: loan (bank), issuing a bond
ü Cash flow: If a company borrows money, it pays interest over this.
ü Do debtholders have a right to these cash flows? Yes, if the company doesn’t
provide these interest payments, then bankruptcy is a potential outcome.
ü Voting power? No, they do not get to vote on the decisions made by a firm.
2. Equity financing
ü Examples: common share
ü Cash flow: dividends, capital gains that can be realised
ü Do shareholders have a right to these cash flows? No. In a year where the
company doesn’t pay dividends and the stock price doesn’t go up, there is
nothing you can do as shareholder (risk that you take).
ü Voting power? Yes, the shareholder buys a share of ownership.
- Is a firm’s value affected by its capital structure?
Value firm = Discounted value of future cash flows
® Optimal capital structure: minimize the weighted average cost of capital.
Re = expected return equity holders
Rd = expected return debt holders
® Interest rate on debt (rd) generally lower than required return on shares (re).
Shareholders take a higher risk, so they demand a higher return. So could we minimize
WACC by finance only with debt? This is answered by Modigliani and Miller who proof
that financing doesn’t matter in perfect capital markets.
§ Capital structure theories
- The leading theories of capital structure:
1. Capital-Structure Irrelevance: the firm value and real investment decisions are
independent of financing. The choice between debt and equity is not totally
unimportant, but its effects on real decisions are second- or third-order.
2. Static trade-off theory: firms choose target debt ratios by trading off the tax
benefits of debt against the costs of bankruptcy and financial distress.
, 3. Agency theory: financing decisions have first-order effects because they change
managers’ incentives and their investment and operating decisions. Agency costs
drive financing – or at least they explain the effects of financing decisions.
4. Pecking-order theory: a firm turns first to the financing sources where differences
in information matter least.
§ 1. The Modigliani–Miller value-irrelevance propositions
- Modigliani and Miller’s proof that financing doesn’t matter in perfect capital markets.
- Example that explains MM:
A firm currently has no debt in its capital structure (all equity firm). The firm is
considering issuing debt to buy back some of its equity.
• The firm’s assets are $8000.
• There are 400 shares of the all-equity firm.
• The proposed debt issue is $4000 (interest rate 10%).
• There are no taxes.
• Return on assets (ROA) are 5%, 15%, or 25%.
Blue line: firm without debt (unlevered firm)
Red line: firm with debt (levered firm)
The line of the levered firm is steeper. This means that investing in this firm is
riskier. You cannot see which firm is better, because we don’t know what will
happen with the value of the assets.
, ® Which strategy is better?
The payoffs of strategy A en B are exactly the same, so the value is the same! That is
the outcome of MM: firm value does not depend on capital structure, because you
have homemade leverage (if a firm does not borrow, you have to borrow yourself).
- MM’s Proposition 1
The value of an asset remains the same, regardless of how the net operating cash
flows generated by the asset are divided between different classes of investors.
PIE THEORY: You cannot change the size of a pie by cutting it into different sized slices
(i) V is a constant, regardless of the proportions of D and E
(ii) Each firm’s cost of capital is a constant, regardless of the debt ratio D/V
® How could this be? We saw before that cost of debt is generally lower than
required return on shares. How can the value of the firm be independent of leverage?
This is explained by M&M Proposition 2.
- MM’ Proposition 2
Solving the equation of cost of capital for the cost of equity gives: rE =rA + (rA −rD)D/E.
rA or r0 = cost of equity of an unlevered firm
“The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm
plus a financial risk premium, which depends on the degree of financial leverage
(more debt means that it is riskier to invest, so shareholders demand a higher return)”
® If you change capital structure, the WACC will not change.
- M&Ms assumptions:
(1) Individuals borrow at the same rate as corporations
® Not realistic: it is cheaper for companies to borrow than for individuals.
(2) Perfect capital market (no information asymmetry or transaction costs)
® Transaction costs may matter: what is more expensive issuing bonds or issuing
shares? It turns out that on average issuing shares is quite expensive (costs are
about 7% compared to bonds of 2%) in terms of transaction costs.
, (3) No taxes
(4) No costs for financial distress
(5) Fixed investment policy: the investments you are doing do not depend on how
they are financed.
- The MM propositions are a starting point. The propositions say that financing does not
affect value except for specifically identified costs or imperfections. As Merton Miller
noted, “showing what doesn’t matter can also show, by implication, what does”.
Lecture 2b: capital structure, static trade-off theory
§ Changing MMs assumptions: Taxes
- In a classical tax system leverage will increase a firm’s value because interest on debt
is a tax deductible expense resulting in an increase in the after-tax net cash flows.
® Dividends are not tax deductable.
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)
First: EBIT = EBITDA – Depreciation & Amortization
Second: EBT = EBIT - Interest
Third: NET EARNINGS = EBT – Taxes
With the net earnings you can pay out dividends or you can retain your earnings.
Because you pay interest before paying taxes, there is a clear advantage of paying interests
- rather
MM than dividends.
Proposition I with taxes:
Value of a levered firm is equal to the value of an unlevered firm of the same risk class
plus the present value of the tax saving
- Personal taxes might matter: if you are an investor and pay very high taxes on your
dividends, then this affects the required return you want to see.
- Conclusion: from a corporate tax perspective debt had a clear advantage. From a
personal tax perspective equity has a slight advantage. But overall debt is still more
beneficial than equity, so the prediction is that a lot of firms use debt to reduce the
taxes they have to pay.
§ Changing MMs assumptions: Costs for financial distress
- You don’t want to have too much debt, because the chance of bankruptcy reduces
firm value.
- Direct and indirect costs of financial distress (or bankruptcy).
a) Direct costs: Lawyer, fire sales (its hard to get a fair price when people know you
are in distress), etc.
b) Indirect costs (for most firms these costs matter more): losing sales already, time
people have to spend to avoid bankruptcy, suppliers who stop deliveries,
employees who not want to work for you firm.
- Average costs of of financial distress: 10-20% firm value.
- The higher the leverage you have, the higher the chance of bankruptcy:
