FINA 351 – Managerial Finance, Chapter 13, Capital Structure, Notes
1. What is Capital Structure (CS)?
It is the mix of debt and equity on the balance sheet. The basic capital structure question is: How
much debt is right for this company? Contrary to what your momma may have taught you,
according to the so-called finance experts too little debt may be just as costly as too much debt,
because debt financing is usually the cheapest source. This is why it is often said that debt is a
two-edged sword: too much is bad but so is too little.
2. Why is CS important?
It directly impacts the cost of capital and therefore directly affects the value and profitability of
the company. For example, at one time Hershey Foods determined that its cost of capital was
13%, significantly more than the cost of capital of its competitors, which put Hershey at a
significant competitive disadvantage. It might have even put Hershey out of business if steps
were not taken to address this issue.
3. Can a company choose its
CS? If so, how?
Yes, within reasonable limits.
If it wants more equity, the
company can issue stock and
pay off debt. If it wants more
debt, it can borrow and with the
proceeds buy back stock. The
last step was what Hershey
Foods did to raise its
debt/equity ratio and thereby
reduce its cost of capital from
13% to 11%. Because of aggressive cost of capital management, Hershey was able to reduce its
WACC from being one of the highest in its industry to being one of the lowest (see graph below).
4. Who were M&M?. Merton Miller and Franco
Modigliani (both deceased) were finance/econ professors at
U. of Chicago and MIT, respectively. They won a Nobel
Prize in Economics for their work on capital structure.
Merton was once asked by a news journalist to summarize
the work he did which won a Nobel Prize. His answer was
too long and complicated for an audience accustomed to
10-second sound bites. Finally, he suggested a simple
analogy: if you cut a pizza into smaller pieces, you’ll have
more pieces but not more pizza. In other words, if you
ignore income tax and financial distress costs, your firm
should be worth the same whether it was financed with all debt or all equity. The news camera
crew folded up their cameras and said they’d get back to him. Merton decided he had somehow
missed his chance to package economic wisdom in 10-second sound-bites.
M&M Theorem and Pizza: After the ball game, the pizza man asked Yogi Berra if the pizza
should be cut into four slices as usual, and Yogi replied: “No, cut it into
eight; I’m hungry tonight.” The moral of the story? More pieces do not
mean more pizza. The main point of the M&M propositions were that if
you ignored taxes and financial distress costs, whether you get your L/T
financing from debt or equity should not matter.
5. Is there an optimum CS? If so, what about M&M’s Proposition Case I?
As illustrated, Case I
shows that the mix of
debt/equity doesn’t
matter if taxes and
financial stress costs
are ignored (the size
of a pizza doesn’t
depend on the number
of pieces). But Case
II and Case III show
that when taxes and
financial distress
(bankruptcy) costs are
considered, the value
of firm most certainly
peaks at an optimum
point. Every CFO has
a target CS for the
optimum level that
minimizes cost of
capital. An executive
at AT&T, for
example, was asked
by a reporter what its
optimum level of debt
was. The executive
answered without
hesitation. So it is
obvious that AT&T
had already put a lot
of thought and study
into this question.
6. Who determines the optimal CS and how?
Management and the board are charged with these important decisions. How they decide differs
from firm to firm but in general they use: (1) internal studies and investment bankers to help
crunch the WACC formulas, (2) follow the industry average, and/or (3) use their intuition.
7. Is the CS of companies similar within an industry?
Yes. Companies in uncertain or cyclical industries (often with higher betas) need the flexibility
that low-debt brings. For example, drug companies might make it big with one product, but they
never know when if the next drug will be approved and how it will sell. Companies in more
stable industries (with
lower betas) are in a better
position to carry higher
debt, such as cable
television. Industries that
require a lot of heavy
industrial equipment or
infrastructure typically
need more L/T financing,
such as airlines or
electrical utilities. On the
other hand, industries with
little infrastructure usually
need little debt, such as
computer software
companies.
8. What is the Overall Pattern of CS in the U.S.?
Debt/Total Assets is about 60% based on book values, but closer to 30% based on market values.
Recently, long-term financing has come from debt more often than equity, with equity financing
actually being negative (more stock repurchased than issued) in some years. However, IPOs have
been picking up lately. Overall, companies in the U.S. have not used debt financing as much as
they could have – there appears to be excess tax shield from debt financing that could be utilized
if desired.
9. At what point is the optimum CS?
The optimum CS is the where the mix between debt and equity (weights) causes the cost of
capital to be at its lowest point.
10. What are the advantages and disadvantages of more debt?
Advantages:
(1) Debt is cheaper than equity financing because interest is tax deductible (dividends are not) and
because it is less risky to investors than equity (i.e. debt investments carry a guaranty of interest
and principal; equity investments carry no such guarantee)
(2) Higher debt brings greater incentive for efficiency – people tend to fight harder with their
backs up against a wall, out of a sense of desperation if nothing else.
(3) Higher leverage brings a greater return on equity to owners. This is one of the main points in
this chapter. Here’s a simple example. Suppose the balance sheet for your business had assets of
$100k, liabilities of $60k, and equity of $40k. If your business made a profit of $20k, you would
have a return on equity of 50% (20k/40k). Supposed instead that your balance sheet was
leveraged with more debt (e.g. assets of $100k, liabilities of $80k, and equity of $20k). Now a
$20k profit creates a return on equity of 100% ($20k/$20k). Notice that debt leverages your
return on equity, in the sense that the more of other people’s money you use (debt), the higher the
return on your equity. You’re using other people’s money as a lever to maximize return on
equity. This is the main reason that many financial firms leading up the financial crisis of 2008
were so highly leveraged. For example, Bear Stearns had $33 of debt for every $1 of equity (i.e.
there was only 3 cents of equity for every dollar of assets). Such high leverage means there is
very little capital to absorb losses, which is why these firms failed.
Disadvantages:
(1) financial distress/bankruptcy costs are very expensive (time, stress, morale, etc.).
(2) when debt gets too high, the cost required for additional debt gets prohibitive (e.g. loan shark
interest rates are always in the double digits).
11. What are two forms of bankruptcy?
Chapter 7: the company is worth more dead than alive – kill the company and sell the assets. But
creditors are often lucky to get pennies on the dollar and owners lose everything.
Chapter 11: the company is worth more alive than dead. The creditors feel there’s a better
chance of getting their money back by altering the terms of the loan, making concessions, and
allowing the company to survive. Many times companies will recover very quickly (e.g., 7Eleven was in Ch. 11 only for a few months.)
Note: there are other forms of bankruptcy as well, such as Chapters 9, 12 & 13. Ch. 9 is for
municipalities, such as Detroit, MI; Jefferson County, AL; Harrisburg, PA; Vallejo, CA; Desert
Hot Springs, CA; or Orange County, CA. Ch. 12 & 13 are similar to Ch. 11 but for farmers (Ch.
12) or other private individuals (Ch. 13) with steady income and smaller amounts of debt.
12. In bankruptcy, in what order are creditors paid off?
Negotiation usually occurs which means that the order below is not always followed. But usually
the claims are paid in the following order:
1. Secured creditors (to the extent that collateral value)
2. Administrative expenses associated with bankruptcy (accountants/lawyers,
courts costs, etc.)
3. Employee compensation owed
4. Consumer claims
5. Government claims
6. Unsecured creditors (e.g. debenture bonds)
7. Preferred stockholders
8. Common stockholders
13. What is an LBO and how does it affect CS?
A leveraged buyout occurs when somebody (management or an outsider) use the proceeds from
debt (usually junk bonds) to buy the stock at a premium from existing owners. This buyout of the
owners adds more debt to the balance sheet. If debt levels were low, this could theoretically bring
the debt level up to the optimum point. The resulting increase in the value of the firm will offset
the cost of the premium offered. But in the past, LBOs have often added too much debt to the
balance sheet, causing the value of firms to eventually decrease (this has occurred about 25% of
the time). An example is the bankruptcy of Federated Dept. Stores (Bloomingdale’s, Macy’s,
Bon-Marche, etc.) when Robert Campeau saddled the company with excessive debt in an LBO.
14. How can Ch. 13 be summarized?
Here’s a simplified picture (summary) of Ch. 13. In a nutshell, it says that a firm with no debt is
not taking advantage of the tax deduction that comes with debt financing. As debt is added, the
tax shield causes the WACC to lower and the value of the firm to increase – but only up to a
point, called the optimal capital structure (OCS), beyond which increased debt levels actually
cause the WACC to increase and the value of the firm to drop, due to financial distress costs.
Level of Debt