Tài chính doanh nghiệp - Chapter 13: Principles of capital structure

Chapter 13Principles of Capital Structure Learning ObjectivesExplain the effects of financial leverage.Distinguish between business risk and financial risk.Understand the ‘capital structure irrelevance’ theory of Modigliani and Miller (MM).Explain the roles of taxes and other factors that may influence capital structure decisions.Learning Objectives (cont.)Understand the concept of an optimal capital structure, based on a trade-off between the benefits and costs of using debt.Explain the ‘pecking order’ theory of capital structure.Outline Jensen’s free cash flow theory.IntroductionCapital structureThe mix of debt and equity finance used by a company.Optimal capital structureThe capital structure which maximises the value of a company.Does the value of the net operating cash flow stream depend on how it is divided between payments to lenders and shareholders?Effects of Financial LeverageBusiness risk The variability of future net cash flows attributed to the nature of the company’s operations (the risk faced by shareholders if the company is financed only by equity).Financial riskThe risk attributable to the use of debt as a source of finance.Effects of Financial Leverage (cont.)Effects of financial leverage:Expected rate of return on equity is increased.Variability of returns to shareholders increases.Increasing leverage involves a trade-off between risk and return.Effects of Financial Leverage (cont.)Measures of financial leverage:Debt to equity, debt to total assets and interest coverage.Leverage varies both within and between industries.For example, in 2004, Woolworths had positive net debt ratios, while David Jones had negative net debt ratios, even though they were both in the same industry.Modigliani & Miller AnalysisAssumptionsCapital markets are perfect.Companies and individuals can borrow at the same interest rate.There are no taxes. There are no costs associated with the liquidation of a company.Companies have a fixed investment policy so that investment decisions are not affected by financing decisions.MM’s Proposition 1The market value of any firm is independent of its capital structure.If a company has a given set of assets, changing debt to equity will change the way net operating income is divided between lenders and shareholders but will not change the value of the company.Value of a company is given by:Proposition 1: ProofTwo companies that have the same assets but different capital structures are, under the assumptions, perfect substitutes. As such, perfect substitutes should have the same value.There is no reason for investors to pay a premium for shares of levered companies because investors can borrow to create ‘home-made leverage’. What if The companies were not selling for the same price?Arbitrage profits could be earned. An opportunity to make riskless profits exists and arbitragers will exploit this. Arbitrage involves buying an asset and simultaneously selling it for a higher price, usually in another market, so as to make a risk-free profit.Illustrating an Arbitrage OpportunityTwo firms, U and L.Firm U is unlevered and Firm L is levered.Firm L has borrowed $400 000 at 7.5%.Both firms make a profit of $900 000.Required return is 10%.We want to show that these two companies are equivalent, otherwise there must be an arbitrage opportunity.Illustrating an Arbitrage Opportunity (cont.)Firm U (unleveraged):Value of equity = $900 000/0.10 = $9 000 000Value of firm = D + E = 0 M + 9 M = $9 000 000Firm L (leveraged):Value of firm = D + E = 4 M + 6 M =$10 000 000The Arbitrage ProcessThe results suggest we sell Firm L and buy Firm U.Calculate the investor’s dollar investment and the return this is generating:Investment:10% of equity of L10% x 6 000 000 = $600 000Return:10% x net income of L10% x 600 000 = $60 000 per annumThe Arbitrage Process (cont.)Borrow an amount such that personal financial leverage is equivalent to the Firm L’s financial leverage.Firm L’s financial leverage: 4M/6MGear individual the same: D/600 000 = 4/6Hence, investor should borrow $400 000 at 7.5%The Arbitrage Process (cont.)To show a higher return for the same investment:work out funds available to invest in the unlevered firm:Sell shares in L $600 000Borrowings $400 000 _________ Total available $1 000 000Thus, we have shorted Firm L and borrowed and will invest in Firm U.The Arbitrage Process (cont.)Work out the return if all of these funds are invested in the unlevered firm:This is a gross return and does not factor in costs.The Arbitrage Process (cont.)Work out the net return:Return from unlevered firm $100 000less Interest on borrowings $ 30 000Net return $ 70 000 per yearThis represents an increase in income of $10 000 per year, as the investor’s old return, by investing in Firm L, was only $60 000 per year.The Arbitrage Process (cont.)It is not necessary for arbitrage transactions to involve personal borrowing. The only requirement is that investors are able to trade in both debt securities and shares.The point is that, if such equivalent firms are not offering the same return, arbitrage is possible.Eventually, the market will force returns to be the same, implying the degree of leverage does not have any impact on firm value and can be replicated by investors.MM’s Proposition 2The 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:MM’s Proposition 3The appropriate discount rate for a particular investment proposal is independent of how the proposal is to be financed.The key factor determining the discount rate or a proposal is the level of risk associated with the project.This is consistent with the irrelevance of the financing decision, Proposition 1.Role of MM’s AnalysisGiven the assumptions, the financing decision has no effect on company value or shareholders’ wealth.Showing what does not matter can also show, by implication, what does matter.For example, we should be able to dismiss claims that financial leverage gives a company something for nothing, i.e. ‘there is no magic in financial leverage’.However, we need to keep in mind MM’s assumptions, such as 'no market imperfections and taxes’.Role of MM’s Analysis (cont.)Contrast with traditional perspective on capital structure.Low levels of leverage can reduce the weighted average cost of capital.Based on idea that equity holders do not perceive higher risks with low leverage levels.MM’s analysis refutes this — average cost of capital cannot be reduced by issuing debt.Including Factors MM ExcludedCapital market imperfections will impede the MM 1958 propositions:Income taxesTransaction costsCosts associated with financial distressAgency costsDifferent cost of borrowing for corporations and individualsNon-constant cost of debtIncorporating TaxesCorporate taxesLeaving all original assumptions in place except to relax the assumption of no corporate tax, MM extended their analysis.Classical systemLeverage 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 to investors.Incorporating Taxes (cont.)Personal taxes (Miller, 1977)Suggested that the presence of taxes on personal income may reduce the tax advantage associated with debt financing.Why? Firms could save corporate taxes by raising the D/E ratio, but investors would pay additional personal tax and, therefore, require higher returns to compensate for this fact and the higher associated risks.Proposition 1 (with Company Tax)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:where represents the present value of the tax shield associated with interest payments.Miller’s AnalysisThe gain from leverage can be identified as: Miller’s Analysis (cont.)Implications:There is an optimal debt–equity ratio for the corporate sector as a whole, which will depend on the company income tax rate and on the funds available to investors who are subject to different tax rates.Securities issued by different companies will appeal to different clienteles of investors. Consequently, in equilibrium there is no optimal debt–equity ratio for an individual company.Shareholders of levered companies end up receiving no benefit from the company tax savings on debt, because the saving is passed on to lenders in the form of a higher interest rate on debt.Incorporating Taxes: Imputation Tax SystemThe imputation tax systemIncome distributed as franked dividends to resident shareholders is effectively taxed only once at the shareholder’s personal tax rate. Interest paid to lenders is only taxed once at lender’s personal tax rate.Incorporating Taxes: Imputation Tax System (cont.)The imputation system has the potential to lead to neutrality between debt and equity.However, there is a possible bias towards equity for investors with personal income tax rates greater than the company tax rate, who may favour companies retaining, rather than distributing, profits to achieve a lower tax burden.In summary, the imputation system has the potential to be neutral and any bias will favour equity rather than debt. Accounting for Other Market ImperfectionsThere are non-tax factors that can cause a company’s value to depend on its capital structure.Financial distressBankruptcy costs Direct and indirect costs.Due to issuing risky debt, a company gives outsiders a potential claim against its assets which decreases the value of the claims held by investors.Bankruptcy CostsIncorporating the benefits and costs of debt, leads to the following expression of the value of a leveraged firm:The PV of expected bankruptcy costs depends on the probability of bankruptcy and PV of costs incurred if bankruptcy occurs.Indirect Costs of Financial DistressFinancial distress leads a range of stakeholders to behave in ways that can disrupt its operations and reduce its value.Effect of lost sales.Reduced operating efficiency.Cost of managerial time devoted to attempts to avert failure (less attention paid to issues such as product quality and employee safety).Agency CostsAgency costs arise from the potential for conflicts of interest between the parties forming the contractual relationships of the firm.Management may make decisions that transfer wealth from lenders to shareholders.Sources of potential conflict:Claim dilution Dividend payoutAsset substitutionUnder-investmentAgency Costs (cont.)Claim dilutionA company may issue new debt which ranks higher than existing debt.Holders of the old debt now have a less secure claim on the company’s assets.Wealth can be transferred from the holders of the old debt to shareholders.Agency Costs (cont.)Dividend payoutA company may significantly increase its dividend payout.This decreases the company’s assets and increases the riskiness of its debt.Again, this results in a wealth transfer from lenders to shareholders.Agency Costs (cont.)Asset substitutionA company’s incentive to undertake risky investments increases because of the use of debt.If risky investments prove successful, most of the benefits will flow to shareholders, but if it fails, most of the costs will be borne by lenders.Undertaking such investments (negative NPV) causes the total value of the company to decrease, but the value of the shares will increase and the value of the debt will fall.Agency Costs (cont.)Under-investmentA company may reject proposed low-risk investments which have a positive net present value.If a company’s debt is very risky it may not be in the interest of shareholders to contribute additional capital to finance new investments.Although the investment is profitable, shareholders may lose because the risk of the debt will fall and its value will increase.Agency Costs (cont.)Potential conflict of interest between lenders and shareholders, and the likelihood of conflict increases with greater financial leverage.Costs borne by shareholders:Higher interest rates, restrictive covenantsAgency Costs (cont.)Conflicts of interest between shareholders and managers. Can be reduced by aligning the objectives of managers with those of shareholders:Employee share ownership schemes.Remuneration for top-level managers in the form of options.Agency Costs (cont.)Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers?NoFew individuals have the combination of wealth and skills to both own and manage a company involved in activities such as large-scale industrial operations.While uniting the functions of management and provision of capital has advantages in terms of agency costs, it has disadvantages in terms of risk bearing (investors can easily diversify by simply combining the shares of many companies in a portfolio).Incentive Effects of DebtTendency for managers to over-invest.Over-investment more likely, the higher the company’s free cash flow.Such free cash flows should ideally be paid out; however, dividends are at the discretion of management.Borrowing forces the payout of cash which reduces the potential for over-investment.Optimal Capital StructureTrade-off theoryThe possibility of a trade-off between the opposing effects of the benefits of debt finance and the costs of financial distress may mean that an optimal capital structure exists. Management should aim to maintain a target debt–equity ratio.Capital Structure with Information AsymmetryPecking order theoryIn raising finance, managers follow a pecking order in which internal funds are preferred, followed by debt, hybrid securities and then, as a last resort, a new issue of ordinary shares.Myers explains this pecking order based on information asymmetry.Information asymmetry is a situation where all relevant information is not known by all interested parties. Typically, this involves company ‘insiders’ (managers) having more information about the company’s prospects than ‘outsiders’ (shareholders and lenders).Capital Structure with Information Asymmetry (cont.)Example:A company has 100 000 ordinary shares with a market price of $4.50, but management believes that the ‘true’ value of the shares is $5.The company has an investment opportunity that requires an outlay of $200 000, has an NPV of $17 000 and will have to be financed externally.The existence of the investment opportunity is not known to the market and is, therefore, not reflected in the current share price.Capital Structure with Information Asymmetry (cont.)Information asymmetry exists with respect to both the company’s existing assets and the new investment.Should the investment be implemented?How should it be financed?Capital Structure with Information Asymmetry (cont.)Information symmetrySuppose that management is able to convey to investors its information about the value of the existing assets, but not the new investment, before it raises funds by making a share issue.Capital Structure with Information Asymmetry (cont.)New shares sold at the market price $5.What is the value of shares after the issue?Since this value >$5, shareholders will benefit from the issue and the project.Capital Structure with Information Asymmetry (cont.)Information asymmetryIf management is unable to convey this information to the market, the shares cannot be sold for more than $4.50.In this case, the new shareholders gain but the old shareholders are better off without the issue and the new project.That is, provided the information asymmetry is removed, the share price should increase to $5.Capital Structure with Information Asymmetry (cont.)Information asymmetry (cont.)If management is unable to convey this information to the market, the shares cannot be sold for more than $4.50.In this case, the new shareholders gain but the old shareholders are better off without the issue and the new project.That is, provided the information asymmetry is removed, the share price should increase to $5.Capital Structure with Information Asymmetry (cont.)Borrowing:If the company borrows to finance the project, all the benefit of the positive NPV will go to the current shareholders and the new share price will be:This is the most attractive option for shareholders.Capital Structure with Information Asymmetry (cont.)Poor prospects:Current share price is $4.50.No new investment opportunity.Due to poor prospects management believes shares are worth only $3.50.50 000 shares are issued while the market price is $4.50 and the proceeds are used to repay debt. Capital Structure with Information Asymmetry (cont.)The value of the shares after this issue when prospects are poor is given by:While this is less than the previous price of $4.50, it is more than the price should have been without the issue ($3.50).Capital Structure with Information Asymmetry (cont.)What do the previous scenarios imply about financing policy?If there is information asymmetry, and management believes that its company’s shares are undervalued, they will prefer to borrow.If management believes the shares are overvalued, they will prefer to issue new shares.Difference between pecking order theory and trade-off theory is that pecking order theory does not depend on target debt–equity ratio.Instead, it is about availability of internal funds and information asymmetry.Capital Structure with Information Asymmetry (cont.)However, outside investors understand managers’ motives and therefore will tend to react to the announcement of a share issue by reducing the company’s share price, because the chances are that the issue signals bad news.Jensen’s Free Cash Flow TheoryInformation asymmetry implies that reserve borrowing capacity is valuable, but it is important to note that its value can differ between companies, depending on investment prospects.Reserve borrowing capacity is more valuable for high growth companies. In more mature, stable companies it can cause free cash flows.Where reserve borrowing capacity results in free cash flows, it offers slack for management.These reserves may not generate adequate returns and should be paid out to investors rather than retained in the company.Jensen (1986) argues that free cash flows should be paid out to investors in order to avoid poor use of funds by managers.Ways of returning funds include dividends and share buyback programs.Debt offers a ‘control effect’ generating a credible commitment not to misuse free cash flow, as it is required to service debt.Jensen’s Free Cash Flow Theory (cont.)SummaryLeverage and its effects on financial risk.Modigliani and Miller — capital structure does not change the value of an entity.If the company tax saved by borrowing is different from the extra tax incurred at the investor level, capital structure can affect the value of companies.Issue of debt has a range of associated costs and benefits: such as expected bankruptcy costs and agency costs.There is a trade-off between costs and benefits in determining optimal capital structure — trade-off theory.Summary (cont.)An alternative to the trade-off theory is the pecking order theory.Information asymmetry can lead managers to have a preference for debt over equity.Jensen argues that free cash flows have the potential to be misused by management.One way to control use of free cash flow and enhance firm value is to increase debt levels, though there are associated risks.