11/9/2001
Lecture
Capital Structure
and the
Modigliani-Miller Propositions
Copyright K. Cuthbertson and D. Nitzsche
1
TOPICS COVERED
Preliminary definitions
~Capital structure question -what is it?
Capital structure question -the theories
~Traditional view
~Modigliani-Miller MM - propositions I and II (no taxes)
~Modigliani-Miller MM - propositions I and II (with taxes)
Modigliani-Miller: More Realism
~Financial Distress and Bankruptcy
Copyright K. Cuthbertson and D. Nitzsche
2
READING
Investments:Spot and Derivative Markets
K.Cuthbertson and D.Nitzsche
CHAPTER 11:
excluding
Section 11.4 (Dividend Policy) and
Appendices
Copyright K. Cuthbertson and D. Nitzsche
3
Preliminary Definitions
Capital structure question -what is it?
Copyright K. Cuthbertson and D. Nitzsche
4
Manufacturing (Leverage =Debt to Equity Ratio)
Manufacturing Sector (UK, E. Midlands, averages 1984-94)
Chemicals
Metals
Mech. Eng.
Construction
Retail Distn
Business Services
140%
90%
76%
75%
158%
125%
Figures are all ‘book value’
Leverage = Total Debt / Net Worth(‘Shareholders Funds’)
Leverage varies greatly even within same sector
Copyright K. Cuthbertson and D. Nitzsche
5
Preliminary Definitions
LEVERED(GEARED) = financed by debt and equity
DISCOUNT RATE TO USE FOR A LEVERED FIRM
Assume (debt-equity ratios will remain broadly unchanged)
(‘After tax’)Weighted Average Cost of Capital WACC,
WACC = (1-z) RS
z = B / V , (1-z) = S / V
+ z RB (1-t)
~ ‘weights’ sum to 1.
Copyright K. Cuthbertson and D. Nitzsche
6
Using the WACC as the discount rate
WACC can be used:
I) if the new project gives rise cash flows that have the same degree
of business risk as the existing general cash flows of the firm.
That is, the project is ‘scale enhancing’
and
ii) if the project does not lead to a (large) change in the firm’s debt
ratio.
In fact, the WACC calculation assumes that the amount of debt
outstanding is rebalanced every period to maintain a constant
ratio B/V ratio for the firm as a whole.
Copyright K. Cuthbertson and D. Nitzsche
7
Capital Structure Question
SO, VALUE OF THE FIRM IS:
V = Y / WACC
Hold the firm’s cash flows constant (and for ever)
(Also, assume Y is independent of capital structure)
CAPITAL STRUCTURE QUESTION
Can we alter WACC (and hence V) by altering the mix of
debt and equity finance ?
Example
.$100 total in debt and equity.
Do we gain by moving from 20% debt/80% equity
finance, to 70% debt-30% equity finance ?
- done by issuing more $50 more in bonds and using the
proceeds to buy-back $50 of outstanding shares.
Copyright K. Cuthbertson and D. Nitzsche
8
Capital Structure: Traditional View
Copyright K. Cuthbertson and D. Nitzsche
9
Capital Structure: Traditional View
As you increase the proportion of ‘cheap’ debt
(and initially the required return on equity remains
constant ) then WACC will fall and hence V will rise.
After a certain debt level (e.g. 70%) the equity holders
will require a higher return because of increased ‘risk’.
This will raise the WACC and V will begin to fall.
Hence: There is a particular level for the debt-equity ratio
which will maximise the value of the firm.
Copyright K. Cuthbertson and D. Nitzsche
10
Traditional View : Cost of Capital
*
VALUE OF FIRM
Cost of
Capital
Equity, Rs
or V
WACC
Debt Rb
Optimal( B/S)*
Debt-Equity Ratio (B/S)
Copyright K. Cuthbertson and D. Nitzsche
Capital Structure:
Modigliani-Miller
Propositions I and II (No taxes)
Copyright K. Cuthbertson and D. Nitzsche
12
Modigliani-Miller Approach
ASSUMPTIONS IN THE MODIGLIANI-MILLER APPROACH
• Borrowing and lending rates equal and the same for companies
and persons.
• No corporate or personal taxes or transactions costs.
• No costs of financial distress or liquidation
• net cash flows Y,are independent of the debt-equity mix.
• Investors can arbitrage between the shares of companies (with
the same business risk) where one is all-equity financed and the
other is a levered firm.
Copyright K. Cuthbertson and D. Nitzsche
13
MM PROPOSITION I (NO TAXES)
Under certain restrictive assumptions MM show
that the fall in WACC as you increase the proportion of
debt finance is exactly offset by the rise in the required
return on equity, RS
- so the overall WACC remains constant.
In this MM world there is therefore no optimal debt-equity
ratio.
So, MM argue that you can finance a project with NPV>0,
with any arbitrary mix of debt and equity, without
affecting the overall value of the firm.
Copyright K. Cuthbertson and D. Nitzsche
14
The Value of the Firm: MM Proposition-I (no taxes)
Value of firm, V
V is independent of B/S
V
Debt-Equity Ratio (B/S)
Copyright K. Cuthbertson and D. Nitzsche
Why Does Rs Increase With Leverage ?
Why do shareholders demand a higher return on
equity Rs as we increase proportion of debt
relative to equity finance ?
Rs increases because these returns are more
uncertain (i.e. have a higher standard deviation)
the larger is the proportion of debt finance.
Copyright K. Cuthbertson and D. Nitzsche
16
Why Does Rs Increase With Leverage ?
Earnings Y can be either £0.5m , £2m or £4m (with
equal probability). This is ‘business risk’.
What is the range of outcomes for shareholder’s returns
Rs in
a) the all (100%) equity financed firm
b) the levered firm with 50% debt and 50% equity
The range is much greater in (b) since the interest
income on the debt is paid first.
Copyright K. Cuthbertson and D. Nitzsche
17
Equity Return, RS
Leverage and Equity Returns
50% Equity
(50% Debt)
C
70%
100% Equity
(0% Debt)
40%
B
30%
20%
A A’
10%
0.5 1
2
4
Earnings Yi
Yi changes from 1m to 4m, RS for the all equity firm moves from 10%
to 40% (A to B)
But for the 50% levered firm the equity return changes much more,
from 10% to 70% (A’ to C).
Hence ‘debt finance’ introduces additional ‘leverage risk’.
Copyright K. Cuthbertson and D. Nitzsche
18
Leverage and Equity Returns
Capital raised=$10m =S + B = shares + debt (bonds)
Cost of Debt =10%
1. Poor 2. Average
Earnings before interest
Y1 = $0.5 Y2 = $2
(equal probability=1/3)
3. Good
Y3 = $4.0
Note (below):
Expected return is calculated
ER = 1/3 R1 + 1/3 R2 +1/3 R3
Standard Deviation is:
‘Sum from k=1 to 3 of [ 1/3( Rk - ER)2 ]
Copyright K. Cuthbertson and D. Nitzsche
19
Leverage and Equity Returns
Earnings before interest, Yi
1. Poor
Y1 = $0.5
2. Average
Y2 = $2
Equity (0% Leverage) ( S = $10m equity)
Debt interest rB
0
0
Earnings/Dividends
$0.5
$2
Return on shares,
Ri = Div/ S
0.5/10 = 5%
2/10 = 20%
3. Good
Y3 = $4.0
.100%
Expected Return (standard deviation)
0
$4
4/10 = 40%
= 21.7% (14.3)
Note (not crucial here!):
R
= Total Earnings / Total value shares
= Earnings per share / Share price
= Div / S
= EPS / PS
where PS = S / N
Copyright K. Cuthbertson and D. Nitzsche
20
Leverage and Equity Returns
Earnings before interest
1. Poor
Y1 = $0.5
2. Average
Y2 = $2
$0.2
$0.3
$0.2
$1.8
3. Good
Y3 = $4.0
..20% Levered (z = B/V = 2/10)
(B= $2m debt, S= $8m equity)
Debt interest rB
Earnings
Ri = Div/ S
$0.2
$3.8
0.3/8 = 3.75% 1.8/8 = 22.5% 3.8/8 = 47.5%
Expected Return (standard deviation)
= 24.6 (17.9)
Copyright K. Cuthbertson and D. Nitzsche
21
SUMMARY SO FAR !
TRADITIONAL VIEW
There is a debt-equity mix which minimises the WACC
and hence maximises the firm’s market value.
MM : ‘PROPOSITION I ’: NO TAXES
The WACC and the value of the firm V are both
independent of the debt-equity mix (used in financing
the firm’s activities)
Copyright K. Cuthbertson and D. Nitzsche
22
MM ‘PROPOSITION II: NO TAXES
Since the WACC (Rw) is independent of debt-equity ratio,
this implies
cost of equity capital Rs rises with the debt-equity ratio B/S
Note: Re-arrange WACC formula, it can be shown that:
RS = Rw + [Rw-Rb] B/S
Rw is constant (MM-1) and Rw - Rb >0
then Rs will rise as B/S increases.
The intuition for this was given above as the ‘increase in leverage risk’
Copyright K. Cuthbertson and D. Nitzsche
23
CONSEQUENCES OF MM(2)
Rs (or Rw or Rb)
RS = Cost of equity
Rs = Rw + [Rw-Rb] B/S
Rw
Rb
Debt-Equity Ratio (B/S)
Cost of equity rises with rising Debt-Equity Ratio
Copyright K. Cuthbertson and D. Nitzsche
24
MM I AND II
WITH
CORPORATE TAXES
( ‘MM-I goes crazy’ )
Copyright K. Cuthbertson and D. Nitzsche
25
MM I AND II ‘WITH TAXES’
MM PROPOSITION I (With Corporate Taxes):
For two firms with the same business risk, then the
optimal debt ratio that maximises the value of the firm
involves 100% leverage (i.e. all debt financed) !
MM Proposition II (with corporate taxes)
There is (still) a positive relationship between the required
return on equity in a levered firm and the debt-equity
ratio BL /SL.
Copyright K. Cuthbertson and D. Nitzsche
26
MM Proposition I (with corporate taxes)
Taxes are paid after deduction of (debt) interest
payments.
As you increase the proportion of ‘cheap’ debt finance:
Rs increases (because of increased ‘risk’)
but this does not completely offset the lower after tax cost
of the debt finance (1-t) Rb .
Hence:
WACC falls continuously and value of a firm (with taxable
profits) reaches a maximum value, at 100% debt finance.
Copyright K. Cuthbertson and D. Nitzsche
27
Modigliani-Miller: More Realism
Financial Distress and Bankruptcy
Copyright K. Cuthbertson and D. Nitzsche
28
MM (with taxes) + Costs Of Financial Distress
Costs of distress
- ‘legal fees’ and the loss in a ‘fire sale’
- difficult relationship with customers and suppliers
- most efficient workers leave - Football teams, Polly Peck,
Rover, M&S, Media and internet co.
Copyright K. Cuthbertson and D. Nitzsche
29
MM (with taxes) + Costs Of Financial Distress
As the B/S increases then probability of ‘distress’ will
increase
then Rb and Rs will increase as will WACC, so V falls.
Then there is a ‘theoretical’ optimal debt-equity ratio in
this ‘new’ MM world
- but it requires measuring some very intangible costs !
Copyright K. Cuthbertson and D. Nitzsche
30
Figure 11.5 : Value of the Firm
(MM-Proposition I with Taxes and Bankruptcy)
.
Value of the Firm
MM-with corporate taxes only
MM-with corporate
taxes and
bankruptcy costs
MM-no taxes
Optimal debt-equity ratio
Debt-Equity Ratio (B/S)
Copyright K. Cuthbertson and D. Nitzsche
More Realism ?: Definitions
Agency costs
costs of ensuring that managers (the agents) act in the
best interests of the shareholders (i.e. the owners or
principals).
Debt agreements (e.g. for bonds, bank loans) usually
contain restrictive covenants(e.g. preclude the
managers from investing in high risk ventures)
Bondholders suffer from information asymmetry.
Copyright K. Cuthbertson and D. Nitzsche
32
More Realism ?: Issues Ignored In MM Model
COSTLY MONITORING implies debt-holders may
require higher Rb as leverage increases.
This increases the WACC and lowers V.
Copyright K. Cuthbertson and D. Nitzsche
33
Issues Ignored in MM Model
Perceived probability and costs of distress depends on;
the greater the variability in earnings, the higher the risk of
liquidation or ‘distress’
costs of distress will be lower the greater the liquidity and
marketability of the firm’s assets
the probability and costs of distress are lower, the higher
the proportion of variable to fixed costs (e.g. can you
quickly reduce staffing costs)
Copyright K. Cuthbertson and D. Nitzsche
34
Issues Ignored in MM Model
Shareholders may persuade managers of ‘near bankrupt’
firm to undertake highly risky projects. - ‘go-for-broke’
strategy - this worries bondholders
advertising firm (with few tangible assets as security)
versus leisure firm(with hotels to sell off, to repay
bondholders).
The latter has a higher ‘debt capacity’ than the former.
Managers keep debt levels low to get the benefit of an
‘option to expand’ into profitable projects.
Copyright K. Cuthbertson and D. Nitzsche
35
Issues Ignored in MM Model
Debt levels might influence future cash flows is if they
affect managerial incentives. Firms with high leverage,
have to meet high interest payments every year.
This may provide incentives for managers to increase
productivity, cut costs and concentrate on their ‘core
competencies’.
Also, highly leveraged firms may not be able to ‘empire
build’ since there are little or no ‘free cashflows’.
Hence, high leverage might
discouraging ‘empire building’.
increase
Copyright K. Cuthbertson and D. Nitzsche
profits
by
36
‘External’ Factors Influence Debt Levels
The pecking order ‘model’ assumes managers
I) use internal funds (retained profits) first, then
ii) debt (loan and bond) markets and finally
ii) equity markets.
High growth firms invest more than retained earnings
and will therefore take up debt and then equity.
Slow growing firms with ‘normal’ profits will not have
any debt since there will be enough internal funds
for all desirable projects
Copyright K. Cuthbertson and D. Nitzsche
37
‘External’ Factors Influence Debt Levels
FI and venture capitalists
might ‘force’ a particular (non-optimal) capital structure on
firms. (i.e. correspondent banking relationships and
venture capitalists on the board - with their preferred
debt-equity mix)
When in financial distress, ‘restructuring is often decided
by a diverse group of creditors (usually a consortium of
banks ) - e.g. Eurotunnel in 1990s and British Telecom
in 2000
Copyright K. Cuthbertson and D. Nitzsche
38
Debt Levels In Practice: Nothing Fits Well !
No easy practical solutions to the capital structure
question once we take into account the complexities of
the real world.
Many influences on the perceived optimal debt-equity mix
-the cost of financial distress/monitoring
-agency and incentive problems
- MBO’s and LBO’s (an unsatisfied ‘clientele’ for this type
of debt)
- debt restructuring ( forced on companies by creditors)
Copyright K. Cuthbertson and D. Nitzsche
39
.
END OF SLIDES
Copyright K. Cuthbertson and D. Nitzsche
40