Chapter 16- Old 10Th Edition

Chapter 16- Old 10th Edition

Capital Structure Decisions: The Basics

MINI-CASE

ASSUME YOU HAVE JUST BEEN HIRED AS BUSINESS MANAGER OF PIZZAPALACE, A PIZZA RESTAURANT LOCATED ADJACENT TO CAMPUS. THE COMPANY’S EBIT WAS $500,000 LAST YEAR, AND SINCE THE UNIVERSITY’S ENROLLMENT IS CAPPED, EBIT IS EXPECTED TO REMAIN CONSTANT (IN REAL TERMS) OVER TIME. SINCE NO EXPANSION CAPITAL WILL BE REQUIRED, PIZZAPALACE PLANS TO PAY OUT ALL EARNINGS AS DIVIDENDS. THE MANAGEMENT GROUP OWNS ABOUT 50 PERCENT OF THE STOCK, AND THE STOCK IS TRADED IN THE OVER-THE-COUNTER MARKET.

THE FIRM IS CURRENTLY FINANCED WITH ALL EQUITY; IT HAS 100,000 SHARES OUTSTANDING; AND P0 = $20 PER SHARE. WHEN YOU TOOK YOUR MBA CORPORATE FINANCE COURSE, YOUR INSTRUCTOR STATED THAT MOST FIRMS’ OWNERS WOULD BE FINANCIALLY BETTER OFF IF THE FIRMS USED SOME DEBT. WHEN YOU SUGGESTED THIS TO YOUR NEW BOSS, HE ENCOURAGED YOU TO PURSUE THE IDEA. AS A FIRST STEP, ASSUME THAT YOU OBTAINED FROM THE FIRM’S INVESTMENT BANKER THE FOLLOWING ESTIMATED COSTs OF DEBT FOR THE FIRM AT DIFFERENT DEBT LEVELS (IN THOUSANDS OF DOLLARS):

AMOUNT BORROWED kd

$ 0 ---

250 10.0%

500 11.0

750 13.0

1,000 16.0

IF THE COMPANY WERE TO RECAPITALIZE, DEBT WOULD BE ISSUED, AND THE FUNDS RECEIVED WOULD BE USED TO REPURCHASE STOCK. PIZZAPALACE IS IN THE 40 PERCENT STATE-PLUS-FEDERAL CORPORATE TAX BRACKET, THE RISK FREE RATE IS 6 PERCENT AND THE MARKET RISK PREMIUM IS 4 PERCENT.

A. NOW, TO DEVELOP AN EXAMPLE WHICH CAN BE PRESENTED TO PIZZAPALACE’S MANAGEMENT TO ILLUSTRATE THE EFFECTS OF FINANCIAL LEVERAGE, CONSIDER TWO HYPOTHETICAL FIRMS: FIRM U, WHICH USES NO DEBT FINANCING, AND FIRM L, WHICH USES $10,000 OF 12 PERCENT DEBT. BOTH FIRMS HAVE $20,000 IN ASSETS, A 40 PERCENT TAX RATE, AND AN EXPECTED EBIT OF $3,000.

1. CONSTRUCT PARTIAL INCOME STATEMENTS, WHICH START WITH EBIT, FOR THE TWO FIRMS.

ANSWER: HERE ARE THE FULLY COMPLETED STATEMENTS:

FIRM U FIRM L

ASSETS $20,000 $20,000

EQUITY $20,000 $10,000

EBIT $ 3,000 $ 3,000

INT (12%) 0 1,200

EBT $ 3,000 $ 1,800

TAXES (40%) 1,200 720

NI $ 1,800 $ 1,080

A. 2. NOW CALCULATE ROE FOR BOTH FIRMS.

ANSWER: FIRM U FIRM L

BEP 15.0% 15.0%

ROI 9.0% 11.4%

ROE 9.0% 10.8%

TIE ¥ 2.5´

A. 3. WHAT DOES THIS EXAMPLE ILLUSTRATE ABOUT THE IMPACT OF FINANCIAL LEVERAGE ON ROE?

ANSWER: CONCLUSIONS FROM THE ANALYSIS:

· THE FIRM’S BASIC EARNING POWER, BEP = EBIT/TOTAL ASSETS, IS UNAFFECTED BY FINANCIAL LEVERAGE.

· FIRM L HAS THE HIGHER EXPECTED ROI BECAUSE OF THE TAX SAVINGS EFFECT:

o ROIU = 9.0%.

o ROIL = 11.4%.

· FIRM L HAS THE HIGHER EXPECTED ROE:

o ROEU = 9.0%.

o ROEL = 10.8%.

THEREFORE, THE USE OF FINANCIAL LEVERAGE HAS INCREASED THE EXPECTED PROFITABILITY TO SHAREHOLDERS. THE HIGHER ROE RESULTS IN PART FROM THE TAX SAVINGS AND ALSO BECAUSE THE STOCK IS RISKIER IF THE FIRM USES DEBT.

· AT THE EXPECTED LEVEL OF EBIT, ROEL > ROEU.

· THE USE OF DEBT WILL INCREASE ROE ONLY IF ROA EXCEEDS THE AFTER-TAX COST OF DEBT. HERE ROA = UNLEVERAGED ROE = 9.0% > kd(1 - T) = 12%(0.6) = 7.2%, SO THE USE OF DEBT RAISES ROE.

· FINALLY, NOTE THAT THE TIE RATIO IS HUGE (UNDEFINED, OR INFINITELY LARGE) IF NO DEBT IS USED, BUT IT IS RELATIVELY LOW IF 50 PERCENT DEBT IS USED. THE EXPECTED TIE WOULD BE LARGER THAN 2.5´ IF LESS DEBT WERE USED, BUT SMALLER IF LEVERAGE WERE INCREASED.

B. 1. WHAT IS BUSINESS RISK? WHAT FACTORS INFLUENCE A FIRM’S BUSINESS RISK?

ANSWER: BUSINESS RISK IS THE UNCERTAINTY ASSOCIATED WITH A FIRM’S PROJECTION OF ITS FUTURE OPERATING INCOME. IT IS ALSO DEFINED AS THE RISK FACED BY A FIRM’S STOCKHOLDERS IF IT USES NO DEBT. A FIRM’S BUSINESS RISK IS AFFECTED BY (1) VARIABILITY IN THE DEMAND FOR ITS OUTPUT, (2) VARIABILITY IN THE PRICE AT WHICH ITS OUTPUT CAN BE SOLD, (3) VARIABILITY IN THE PRICES OF ITS INPUTS, (4) THE FIRM’S ABILITY TO ADJUST OUTPUT PRICES AS INPUT PRICES CHANGE, AND (5) THE AMOUNT OF OPERATING LEVERAGE USED BY THE FIRM.

B. 2. WHAT IS OPERATING LEVERAGE, AND HOW DOES IT AFFECT A FIRM’S BUSINESS RISK?

ANSWER: OPERATING LEVERAGE IS THE EXTENT TO WHICH FIXED COSTS ARE USED IN A FIRM’S OPERATIONS. IF A HIGH PERCENTAGE OF THE FIRM’S TOTAL COSTS ARE FIXED, AND HENCE DO NOT DECLINE WHEN DEMAND FALLS, THEN THE FIRM IS SAID TO HAVE A HIGH DEGREE OF OPERATING LEVERAGE. OTHER THINGS HELD CONSTANT, THE GREATER A FIRM’S DEGREE OF OPERATING LEVERAGE, THE GREATER ITS BUSINESS RISK.

C. 1. WHAT IS MEANT BY FINANCIAL LEVERAGE AND FINANCIAL RISK?

ANSWER: FINANCIAL LEVERAGE REFERS TO THE USE OF DEBT AND PREFERRED STOCK IN FINANCING THE FIRM. FINANCIAL RISK IS THE ADDITIONAL RISK BORNE BY THE STOCKHOLDERS AS A RESULT OF THE FIRM’S USE OF DEBT.

C. 2. HOW DOES FINANCIAL RISK DIFFER FROM BUSINESS RISK?

ANSWER: BUSINESS RISK DEPENDS ON A NUMBER OF FACTORS SUCH AS COMPETITION, LIABILITY EXPOSURE, AND OPERATING LEVERAGE. CONVERSELY, FINANCIAL RISK DEPENDS ONLY ON THE AMOUNT OF DEBT FINANCING.

D. NOW CONSIDER THE FACT THAT EBIT IS NOT KNOWN WITH CERTAINTY, BUT RATHER HAS THE FOLLOWING PROBABILITY DISTRIBUTION:

ECONOMIC STATE PROBABILITY EBIT

BAD 0.25 $2,000

AVERAGE 0.50 3,000

GOOD 0.25 4,000

REDO THE PART A ANALYSIS FOR FIRMS U AND L, BUT ADD BASIC EARNING POWER (BEP), RETURN ON INVESTMENT (ROI), [DEFINED AS (NET INCOME + INTEREST)/(DEBT + EQUITY)], AND THE TIMES-INTEREST-EARNED (TIE) RATIO TO THE OUTCOME MEASURES. FIND THE VALUES FOR EACH FIRM IN EACH STATE OF THE ECONOMY, AND THEN CALCULATE THE EXPECTED VALUES. FINALLY, CALCULATE THE STANDARD DEVIATION AND COEFFICIENT OF VARIATION OF ROE. WHAT DOES THIS EXAMPLE ILLUSTRATE ABOUT THE IMPACT OF DEBT FINANCING ON RISK AND RETURN?

Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc. Mini Case: 16 - 1

ANSWER: HERE ARE THE PRO FORMA INCOME STATEMENTS:

FIRM U FIRM L

BAD AVG. GOOD BAD AVG. GOOD

PROB. 0.25 0.50 0.25 0.25 0.50 0.25

EBIT $2,000 $3,000 $4,000 $2,000 $3,000 $4,000

INTEREST 0 0 0 1,200 1,200 1,200

EBT $2,000 $3,000 $4,000 $ 800 $1,800 $2,800

TAXES (40%) 800 1,200 1,600 320 720 1,120

NI $1,200 $1,800 $2,400 $ 480 $1,080 $1,680

BEP 10.0% 15.0% 20.0% 10.0% 15.0% 20.0%

ROI* 6.0% 9.0% 12.0% 8.4% 11.4% 14.4%

ROE 6.0% 9.0% 12.0% 4.8% 10.8% 16.8%

TIE ¥ ¥ ¥ 1.7´ 2.5´ 3.3´

E(BEP) 15.0% 15.0%

E(ROI) 9.0% 11.4%

E(ROE) 9.0% 10.8%

sROE 2.12% 4.24%

CVROE 0.24 0.39

E(TIE) ¥ 2.5´

*ROI = (NI + INTEREST)/TOTAL FINANCING.

THIS EXAMPLE ILLUSTRATES THAT FINANCIAL LEVERAGE CAN INCREASE THE EXPECTED RETURN TO STOCKHOLDERS. BUT, AT THE SAME TIME, IT INCREASES THEIR RISK.

· FIRM L HAS A WIDER RANGE OF ROEs AND A HIGHER STANDARD DEVIATION OF ROE, INDICATING THAT ITS HIGHER EXPECTED RETURN IS ACCOMPANIED BY HIGHER RISK. TO BE PRECISE:

sROE (UNLEVERAGED) = 2.12%, AND CV = 0.24. sROE (LEVERAGED) = 4.24%, AND CV = 0.39.

THUS, IN A STAND-ALONE RISK SENSE, FIRM L IS TWICE AS RISKY AS FIRM U--ITS BUSINESS RISK IS 2.12 PERCENT, BUT ITS STAND-ALONE RISK IS 4.24 PERCENT, SO ITS FINANCIAL RISK IS 4.24% - 2.12% = 2.12%.

E. HOW ARE FINANCIAL AND BUSINESS RISK MEASURED IN A STAND-ALONE RISK FRAMEWORK?

ANSWER: A FIRM’S STAND-ALONE RISK (TO ITS STOCKHOLDERS) IS THE SUM OF ITS BUSINESS AND FINANCIAL RISK:

STAND-ALONE RISK = BUSINESS RISK + FINANCIAL RISK.

WITHIN A STAND-ALONE RISK FRAMEWORK, BUSINESS RISK CAN BE MEASURED BY THE STANDARD DEVIATION OF THE ROE FOR AN UNLEVERAGED FIRM AND STAND-ALONE RISK CAN BE MEASURED BY THE STANDARD DEVIATION OF THE ROE FOR A LEVERAGED FIRM. THESE EQUATIONS SET FORTH THE SITUATION:

STAND-ALONE RISK =sroe.

BUSINESS RISK = sroe(U).

FINANCIAL RISK FOR A LEVERAGED FIRM = sroe - sroe(U).

HAMADA COMBINED THE CAPM AND THE MM WITH-CORPORATE-TAXES MODEL TO OBTAIN THIS EXPRESSION FOR BETA OF A LEVERAGED FIRM:

b = bU + bU(1 - T)(D/E)

= + .

AN UNLEVERAGED FIRM’S BETA IS DETERMINED SOLELY BY ITS BUSINESS RISK, BUT BETA RISES AS LEVERAGE INCREASES. THUS, IN A MARKET RISK FRAMEWORK, BUSINESS RISK IS MEASURED BY THE UNLEVERAGED BETA, bu; FINANCIAL RISK IS MEASURED BY THE CHANGE IN BETA; AND STAND-ALONE RISK IS MEASURED BY THE LEVERAGED BETA, b:

BUSINESS RISK = bU.

FINANCIAL RISK = b – bU = bU(1 - T)(D/E)

TOTAL MARKET RISK = b.

F. WHAT DOES CAPITAL STRUCTURE THEORY ATTEMPT TO DO? WHAT LESSONS CAN BE LEARNED FROM CAPITAL STRUCTURE THEORY?

ANSWER: CAPITAL STRUCTURE THEORY PROVIDES SOME INSIGHTS INTO THE VALUE OF DEBT VERSUS EQUITY FINANCING. AN UNDERSTANDING OF CAPITAL STRUCTURE THEORY WILL AID A MANAGER IN FINDING HIS OR HER FIRMS OPTIMAL CAPITAL STRUCTURE.

MODERN CAPITAL STRUCTURE THEORY BEGAN IN 1958, WHEN MODIGLIANI AND MILLER PROVED, UNDER A VERY RESTRICTIVE SET OF ASSUMPTIONS, INCLUDING THE ASSUMPTION OF NO TAXES, THAT A FIRMS VALUE IS UNAFFECTED BY ITS CAPITAL STRUCTURE. MM’S RESULTS SUGGEST THAT IT DOESN’T MATTER HOW A FIRM FINANCES ITS OPERATIONS BECAUSE CAPITAL STRUCTURE IS IRRELEVANT. DESPITE ITS UNREALISTIC ASSUMPTIONS, MM’S IRRELEVANCE RESULT IS EXTREMELY IMPORTANT. BY INDICATING THE CONDITIONS UNDER WHICH CAPITAL STRUCTURE IS IRRELEVANT, MM ALSO PROVIDED US WITH SOME CLUES ABOUT WHAT IS REQUIRED FOR CAPITAL STRUCTURE TO BE RELEVANT, AND HENCE, TO AFFECT A FIRMS VALUE.

MM LATER CONSIDERED THE IMPACT OF CORPORATE TAXES. BECAUSE INTEREST PAYMENTS ARE DEDUCTIBLE FOR TAX PURPOSES, THE TOTAL CASH FLOWS TO ALL INVESTORS ARE GREATER FOR A LEVERAGED FIRM THAN AN UNLEVERAGED FIRM. EACH DOLLAR OF DEBT, D, INCREASES THE VALUE OF THE FIRM BY TCD, WHERE TC IS THE CORPORATE TAX RATE. TCD IS CALLED THE “TAX SHIELD” OF DEBT. MM’S MODEL IMPLIES THAT FIRMS SHOULD HAVE 100% DEBT FINANCING.

MILLER LATER CONSIDERED THE IMPACT OF PERSONAL AND CORPORATE TAXES. BECAUSE INCOME FROM DEBT TO INVESTORS IS FULLY TAXABLE BUT CAPITAL GAINS FROM STOCK APPRECIATION ARE SUBJECT TO LOWER EFFECTIVE TAXES, THERE IS A SMALLER ADVANTAGE TO DEBT. THE RESULTING VALUE OF THE DEBT SHIELD IS:

,

WHERE Ts IS THE EFFECTIVE PERSONAL TAX RATE ON STOCKS AND Td IS THE EFFECTIVE PERSONAL TAX RATE ON DEBT. BECAUSE Ts < Td, THE NEW TAX SHIELD IS LESS THAN TCD, THE CASE IN WHICH ONLY CORPORATE TAXES ARE CONSIDERED. HOWEVER, THE MODEL STILL IMPLIES THAT 100% DEBT IS OPTIMAL, UNLESS (1 - TC)(1 - Ts) = (1 - TD), IN WHICH CASE THERE IS NO OPTIMAL CAPITAL STRUCTURE.

WHEN BANKRUPTCIES ARE CONSIDERED, THERE IS A TRADE-OFF BETWEEN THE TAX SHIELD ON DEBT AND THE LIKELIHOOD OF FINANCIAL DISTRESS. AT LOW LEVELS OF DEBT, THE TAX SHIELD ON DEBT IS GREATER THAN THE EXPECTED COSTS OF FINANCIAL DISTRESS. AT HIGH LEVELS OF DEBT, EXPECTED BANKRUPTCY COSTS EXCEED THE TAX SHIELD. THIS IMPLIES THAT THERE IS AN OPTIMAL LEVEL OF DEBT.

SIGNALING THEORY RECOGNIZES THAT MANAGERS HAVE BETTER INFORMATION THAN INVESTORS. THIS IMPLIES THAT MANAGERS WOULD SELL STOCK WHEN THE PRICE OF THE STOCK IS GREATER THAN ITS TRUE VALUE. INVESTORS KNOW THIS, AND SO STOCK PRICE SHOULD FALL WHEN COMPANIES ISSUE DEBT.

AGENCY COSTS ARE PRESENT WHEN MANAGERS WASTE FREE CASH FLOW ON PERQUISITES OR NEGATIVE NPV PROJECTS. HIGH LEVELS OF DEBT “BOND” THE FREE CASH FLOW, SINCE MUCH OF THE FREE CASH FLOW MUST BE COMMITTED TO SERVICING THE DEBT. THIS PREVENTS MANAGERS FROM WASTING FREE CASH FLOW, AND SO HIGH LEVELS OF DEBT SHOULD REDUCE AGENCY COSTS.

G. WITH THE ABOVE POINTS IN MIND, NOW CONSIDER THE OPTIMAL CAPITAL STRUCTURE FOR PIZZAPALACE.

1. WHAT VALUATION EQUATIONS CAN YOU USE IN THE ANALYSIS?

ANSWER: SINCE PIZZAPALACE PAYS OUT ALL OF ITS EARNINGS AS DIVIDENDS, AND HENCE IS A NO-GROWTH FIRM, THIS FORMULA APPLIES:

S = = = .

FOR ALL FIRMS, WHETHER ZERO GROWTH OR NOT:

V = D + S

AND: WACC = (D/V)(kd)(1 - T) + (S/V)(ks).

G. 2. COULD EITHER THE MM OR THE MILLER CAPITAL STRUCTURE THEORIES BE APPLIED DIRECTLY IN THIS ANALYSIS, AND IF YOU PRESENTED AN ANALYSIS BASED ON THESE THEORIES, HOW DO YOU THINK THE OWNERS WOULD RESPOND?

ANSWER: THE MM AND MILLER MODELS COULD NOT BE APPLIED DIRECTLY BECAUSE AT LEAST ONE ASSUMPTION IS CLEARLY VIOLATED: kd IS NOT A CONSTANT OVER ALL DEBT LEVELS. THE VARIOUS CAPITAL STRUCTURE THEORIES CAN PROVIDE SOME GUIDELINES, BUT THE ACTUAL EQUATIONS BASED ON THE THEORY ARE BASED ON SO MANY INVALID ASSUMPTIONS THAT THEIR DIRECT REAL-WORLD APPLICATION IS HIGHLY QUESTIONABLE. MOST ACADEMICIANS WHO BECOME INVOLVED WITH REAL-WORLD APPLICATIONS HAVE CONCLUDED THAT IT IS NECESSARY TO MAKE SUBJECTIVE ESTIMATES OF THE RELATIONSHIPS BETWEEN CAPITAL COSTS AND LEVERAGE, AND TO TAKE INTO ACCOUNT (IN A SUBJECTIVE MANNER) FINANCIAL DISTRESS AND AGENCY EFFECTS. HOWEVER, THE THEORY IS EXTREMELY USEFUL TO PROVIDE A CONCEPTUAL FRAMEWORK FOR CONSIDERING CAPITAL STRUCTURE DECISIONS.

H. 1. DESCRIBE BRIEFLY, WITHOUT USING ANY NUMBERS, THE SEQUENCE OF EVENTS THAT WOULD TAKE PLACE IF PIZZAPALACE DOES RECAPITALIZE.

ANSWER: FIRST, PIZZAPALACE SHOULD ANNOUNCE ITS RECAPITALIZATION PLANS (TO HEAD OFF POTENTIAL LAWSUITS). THEN INVESTORS WOULD REASSESS THEIR VIEWS CONCERNING THE FIRM’S PROFITABILITY AND RISK, AND ESTIMATE A NEW VALUE FOR THE EQUITY. NO CURRENT SHAREHOLDER WOULD BE WILLING TO SELL AT A PRICE BELOW THE EXPECTED NEW EQUILIBRIUM PRICE, SO THE STOCK PRICE WOULD QUICKLY ADJUST TO THE NEW EQUILIBRIUM, WHICH WOULD REFLECT THE RECAPITALIZATION EVEN THOUGH IT HAD NOT YET TAKEN PLACE. FINALLY, PIZZAPALACE WOULD ISSUE THE DEBT AND THEN USE THE PROCEEDS TO REPURCHASE STOCK AT THE NEW EQUILIBRIUM PRICE, NOT AT THE PRE-ANNOUNCEMENT PRICE. AFTER THE RECAPITALIZATION, PIZZAPALACE WOULD HAVE MORE DEBT BUT FEWER COMMON SHARES OUTSTANDING.

H. 2. WHAT WOULD BE THE NEW STOCK PRICE IF PIZZAPALACE RECAPITALIZED AND USED THESE AMOUNTS OF DEBT: $250,000; $500,000; $750,000?

3. HOW MANY SHARES WOULD REMAIN OUTSTANDING AFTER RECAPITALIZATION UNDER EACH DEBT SCENARIO?

ANSWER: HERE IS THE ANALYSIS FOR $250,000 OF DEBT (IN THOUSANDS OF DOLLARS AND SHARES):

D = $250:

First calculate kSU before adding debt and then bU:

so kSU = 300/2,000 = 15%.

15% = kRF + bU x Market Risk Premium = 6% + bU 4%

so bU = (15-6)/4 = 2.25.

After adding 250 in debt, E = 1,750 and the new beta, bl will be

bl = bU (1 + (1 – T)(D/E)) = 2.25(1 + 0.6(250/1,750)) = 2.44

kS = 6% + 2.44 x 4% = 15.77%

V1 = S1 + D1 = $1,807 + $250 = $2,057.

P1 = = = $20.57.

SHARES REPURCHASED = = 12.15.

SHARES REMAINING = n1 = 100 – 12.15 = 87.85.

CHECK ON STOCK PRICE:

P1 = = = $20.57.

A FEW COMMENTS ARE IN ORDER:

· SINCE THE $250,000 IN CASH WILL BE USED TO REPURCHASE SHARES, THIS $250,000 WILL GO TO THE STOCKHOLDERS, AND HENCE THE ENTIRE $2,057,000 OF MARKET VALUE IS “OWNED” BY THE 100,000 SHARES CURRENTLY OUTSTANDING. THUS, THE VALUE PER SHARE IS $20.57: