Understanding Capital Structure: Debt vs
. Equity Explained
School
London School of Economics**We aren't endorsed by this school
Course
FM 431L
Subject
Economics
Date
Dec 10, 2024
Pages
27
Uploaded by AmbassadorBravery15766
1/27Lecture 3: Capital StructureInstructor: Dr. Cynthia BallochLondon School of EconomicsFM431
2/27Financing firm assets: debt and equityIDebt and equity are the most common forms of “promises” thatcorporations sell to investors in order to finance their assetsIPromises may be claims, assets, securities, or financial contractsICommon contractual features of debt and equity:1.Payo↵structure: Debt promises fixed payments, equity doesn’t2.Maturity: Debt (usually) matures, equity has no maturity date3.Seniority: Debt is “senior” to equity4.Voice: Equity has voting rights at company annual general meetings(director elections, shareholder proposals, proxy fights), debt doesn’t– instead comes bundled with “protective covenants”
3/27The big question in financing?Does it make a di↵erence to the firm’s value (and thus to shareholderwealth) what mixture of claims is sold to finance the firm’s assets?The mixture of claims is called capital structure.How to add value on the right-hand side of the balance sheet bycapital structure choices?Let’s take a quick look at what real world firms do, to form some basis tothink about this.
4/27Net External Financing and Capital Expenditures by U.S.Corporations, 1975–2021Source: Federal Reserve, Flow of Funds Accounts of the United States, 2021.
5/27Do Firms Prefer Debt?IWhen firms raise new capital from investors, they do so primarily byissuing debtIIn most years, aggregate equity issues are negative, meaning that onaverage, firms are reducing the amount of equity outstanding bybuying sharesIWhile firms seem to prefer debt when raising external funds, not allinvestment is externally fundedMost investment and growth is supported by internally generated fundsIEven though firms have not issued new equity, the market value ofequity has risen over time as firms have grownIFor the average firm, the result is that debt as a fraction of firmvalue has varied in a range from 30% to 45%
6/27Debt-to-Value Ratio of U.S. Firms, 1975-2021Source: Compustat and Federal Reserve, Flow of Funds Accounts of the UnitedStates, 2021.
7/27Does firm value depend on capital structure?To consider capital structure requires a measure of overall cost of capital.For any firm, the cost of capital is the average ofIthe expected rate of return required by investors on its equity, andIthe expected rate of return required by investors on its debtweighted by the proportions of the balance sheet that are financed withequity and debt respectively.If investors expect a ratereon equity andrdon debt, the market value ofequity on the firm’s balance sheet isE, and the market value of debt isD, then the cost of capital is:EE+Dre+DE+Drd
8/27Historical returns on equity and debtBonds have a lower average rate of return than stocks:InvestmentAverage Annual ReturnSmall stocks18.7%S&P 50012.0%Corporate bonds6.2%Treasury bills3.4%Source: Berk and DeMarzo, Table 10.3Can we reduce cost of capital by having more debt and less equity?INo!IIssuing more debt makes cash flows to equity holders riskier
9/27Trade o↵s between debt and equityWhen cash flows are risky, issuing more debt increases the risk to cashflows to equity holders, so the required rate of return on equity goes up.IUsing more of “low-cost” financing doesn’t necessarily reduce theoverall cost of capitalITwo o↵setting e↵ects:(E1)Using a lower-cost form of financing (debt) lowers the cost of capital(E2)Doing so makes higher-cost form of financing (equity) more expensiveIUnder specific conditions, these two e↵ects exactly o↵set each other:a “frictionless economy” or “Modigliani and Miller”
10/27Modigliani and Miller (“frictionless economy”) conditions1.No taxes2.No costs of financial distress3.Firm’s (real) investment decisions are una↵ected by leverage4.No asymmetric information or di↵erence of opinion5.Competitive, unsegmented financial markets, no transaction costsUnder (1)-(5), the market value of a firm is una↵ected by its capitalstructure choice.Note: (1), (2) and (3) guarantee that actual firm cash flows areuna↵ected by leverage, (4) guarantees that everyone agrees on suchpresent values, and (5) guarantee that prices are present values of thesecash flows.
11/27Modigliani-Miller theoremUltimately, the value of a firm derives from the value of the cash flowsgenerated by its operating assets (e.g., plant and inventories).IFirm financial policy slices up this “pie” among di↵erent claimants(e.g., debtholders and equityholders).IThe size (i.e., value) of the pie is independent of it is sliced up.Intuition of the MM theorem:1.If firm cash flows are una↵ected by leverage (conditions 1, 2 and 3),discount rates must also be unchanged.2.If neither cash flows (the numerator in the present value) or thediscount rate (the denominator in the present value) change, thenthe present value, i.e., the market value, of the firm cannot changeeither!
12/27The Asset Cost of CapitalWhat is the discount rate for asset cash flowsra?IUnder MM(1)-(5), the asset cost of capital (ra) is the cost of capital:ra=EE+Dre+DE+Drd(1)because all cash flows from firm assets go to either creditors orshareholders (there are no other claimants e.g., tax authorities)IUnder MM,rais una↵ected by leverage, i.e., E1 and E2 cancel outNotes:1.With taxation there are other claimants against cash flows fromassets so it’s a bit less simple.2.But, ifDD+Eis stable, the above formula still holds.3.E1 and E2 hold generally, even outside frictionless benchmark
13/27Example: Valuing an established firmConsider an established firm at a mature stage, operating in a tax haven,with no asymmetric information, and real assets are held constant (i.e.,MM conditions hold). The firm generates cash flows in perpetuity, whichcan be higher or lower than expected, as below. There is no CAPEX,depreciation, amortization, or changes in NWC. The firm has 10 millionshares.HighExpectedLowEBIT302010Interest Payments000Net Income302010Earnings per Share (EPS)321Suppose that the discount rate that appropriately reflects the risk of cashflows is 10%. What is firm value?
14/27Example: Leveraged recapitalizationSuppose now that the firm undertakes a leveraged recapitalization byissuing perpetual debt to repurchase 5 million shares. Cost of debt is 7%.Does firm value increase?
15/27Example: Leveraged recapitalization and EPSThe share price also will not change: post recapitalization, there are 5million shares outstanding, so the share price must be equal to:Share price =ENumber of Shares outstanding=1005= 20IFive million shares cost 100 million (5⇥20)IShares outstanding is now 5m, debt is 100, interest payments 7HighExpectedLowEBIT302010Interest Payments777Net Income23133EPS4.62.60.6IHow can this be consistent with a higher earnings per share?
16/27Although expected EPS rises, the risk of EPS also rises
17/27Leverage and equity riskIf equity risk increases, the required return to equity also increasesIn this example, we can also write the share price as:Share price =Expected EPSre=Expected cash flows to shareholdersRequired rate of return on equityIPre-recapitalization share price 2/0.1 = 20IPost-recapitalization share price 2.6/re= 20The cost of equity post-recapitalization must then be equal tore=2.620= 13%
18/27What about the cost of capital?Recall that:ra=EE+Dre+DE+DrdPre-recapitalization:D= 0,E= 200,rd= 7% andre= 10%. So:ra=200200 + 010% +0200 + 07% = 10%Post-recapitalization:D= 100,E= 100,rd= 7% andre= 13%.ra=100100 + 10013% +100100 + 1007% = 10%The cost of capital is unchanged: the increase in the cost of equityexactly o↵sets the e↵ect of taking on (cheaper) leverage.
19/27Return on equity, reconsideredRecall thatROE=NI/SE, where SE is the book value of shareholder’sequity. Suppose the book value of assets of the firm pre-recapitalizationwas 130 million.IMarket value of equity pre-recapitalization was 200; post-recap 100IUsually, book values are smaller than market values, as they arehistorical costsINo assets bought or sold in recapitalization, so post-recapitalizationbook asset value is still 130IAt issue, the book value of debt is the same as market valueIThis implies the book value of equity is now 130-100 = 30ISince net income was 20 pre-recapitalization, and is 13post-recapitalization, this implies:ROEpre= 20/130 = 15%ROEpost= 13/30 = 43%
20/27The real world is not frictionlessMM doesn’t directly relate to everyday choices, but does tell ussomething important about how to think about financing choices:IRegardless of conditions 1-3, if the cash flows from assets do notchange, then by definitionrais also unchanged (same cash flows,same discount rate)ISo, how can financing decisions change firm value?Financing choices only matter if they a↵ect cash flows:IFinancing choices are all about changes on the right-hand side of thecorporate balance sheet.ITo make good choices on the right-hand side of the balance sheet,you must look left!IIn other words, the best way to evaluate the goodness of right-handside decisions is to determine their e↵ect on the left-hand side
21/27Capital structure and corporate taxesFinancial policy matters because it a↵ects a firm’s tax bill.For firms, di↵erent financial transactions are taxed di↵erently:IInterest expenses are tax exemptIDividends and retained earnings are taxedIntuition:IMM: in a frictionless world, the size of the pie is una↵ected bycapital structureIWith taxation (a friction), tax authorities get a sliceIFinancial policy a↵ects the size of that slice: interest paymentsbeing tax deductible, the size of the tax authority’s slice can bereduced by using debt rather than equityIValue of levered firm = Value of unlevered firm + PV(tax shields)
22/27Example: Capital structure and taxesNow return to our earlier example. Consider the firm is all equity financedbut now pays corporate taxes of 40%. The discount rate is 10%, andthere are 10 million shares outstanding. What is the value of the firm?
23/27Example: Capital Structure and TaxesSuppose the firm announces that it will imminently issue 100 milliondollars of perpetual debt, at a 7% annual coupon, and will use theproceeds immediately to repurchase shares. How will this change firmvalue?
24/27A simple formula to value tax shieldsFor a constant amount of debt with market valueDat a rate of returnrd, with corporate tax ratet, the present value of tax shieldsPV(tax shields) is given by:PV(tax shields) =⌧rdDrd=⌧DThe total market value of the firm following a leveraged recapitalizationusing perpetual (or constant) debtDis the sum of its original marketvalue without leverage and the present value of the tax shields generatedby the recapitalization:VL=VU+⌧DThis is often referred to as the Modigliani and Miller theorem with taxes.
25/27Computing tax shields, general approachIf debt changes over time, and/or the tax shield is not riskless:1.Compute forecasted cash flows and forecasted tax shield2.Compute an appropriate discount rate for the forecasted tax shields3.Discount to getPV(tax shields)In general,VL=VU+VTSThis is an example of the Adjusted Present Value method for valuation.
26/27Example: Tax shields and stock pricesIf the firm issues$100 million in debt to repurchase shares, the value ofthe firm increases. Will the stock price go up as well? How many shareswill the firm be able to repurchase?
27/27Summary and implicationsIn this lecture:1.Without frictions, firm value is independent of capital structure2.But, equity risk and required returns to equity vary3.Real world is not frictionless, taxes a↵ect firm valueGenerally,IDebt lowers the cost of capital (E1)IDoing so makes equity more expensive (E2)IWhich e↵ect is greater will depend on frictionsThis week’s case: Swedish Match