Capital Structure Theory: Finance

Finance Mihir A. Desai, Series Editor

+ INTERACTIVE ILLUSTRATIONS

Capital Structure Theory TIMOTHY A. LUEHRMAN

5187 | Published: June 26, 2016

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Table of Contents 1 Introduction ........................................................................................................................................................................................ 3 2 Essential Reading ............................................................................................................................................................................ 4 2.1 Characteristics of Debt and Equity Securities .................................................................................................... 4 2.1.1 Debt .................................................................................................................................................................................. 4 2.1.2 Equity .............................................................................................................................................................................. 5

2.2 Measuring Leverage ............................................................................................................................................................. 6 2.3 The Financial Effects of Leverage .............................................................................................................................. 7 2.3.1 The Effect of Leverage on Measures of Financial Performance ............................................... 7 2.3.2 The Effect of Leverage on Risk ...................................................................................................................... 9 2.4 Modigliani and Miller Proposition I: Capital Structure Irrelevance and Firm Value ................ 11 2.4.1 Financing with 100% Equity ............................................................................................................................ 12 2.4.2 Financing with Debt and Equity ................................................................................................................. 13 2.4.3 Arbitrage and Firm Value ................................................................................................................................ 14 2.5 Modigliani and Miller Proposition II: The Effect of Leverage on the Cost of Capital............. 18 2.6 Relaxing M&M Conditions: The Static Trade-off Model ............................................................................. 22 2.6.1 Taxes ............................................................................................................................................................................. 22 2.6.2 Costs of Financial Distress ............................................................................................................................. 24 2.6.3 The Static Trade-off Model ............................................................................................................................ 26 2.7 Relaxing Other M&M Conditions ............................................................................................................................... 30 2.7.1 Agency Costs .......................................................................................................................................................... 30 2.7.2 Asymmetric Information and Pecking Order Theory .................................................................... 31 2.7.3 Product Market Models ..................................................................................................................................... 34 3 Supplemental Reading.............................................................................................................................................................. 34 3.1 Resetting Capital Structure .......................................................................................................................................... 34 3.1.1 Debt Overhang ....................................................................................................................................................... 35 3.1.2 Asymmetric Information and Signaling ................................................................................................. 38 3.1.3 Implications of Debt Overhang and Signaling for Capital Structure Choice ................ 38 3.2 Practice and Complexity ................................................................................................................................................ 39 4 Key Terms ......................................................................................................................................................................................... 42 5 Notation.............................................................................................................................................................................................. 44 6 Practice Questions....................................................................................................................................................................... 45 7 Endnotes ............................................................................................................................................................................................ 45 8 Index ..................................................................................................................................................................................................... 46

This reading contains links to online interactive illustrations, denoted by the icon above. To access these exercises, you will need a broadband Internet connection. Verify that your browser meets the minimum technical requirements by visiting http://hbsp.harvard.edu/tech-specs.

Former Harvard Business School professor Timothy A. Luehrman developed this Core Reading with the assistance of writer Barbara Wall Lobosco, HBS MBA 1995. Copyright © 2016 Harvard Business School Publishing Corporation. All rights reserved.

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1 INTRODUCTION

I

n this reading we will explore basic theories of capital structure—the proportions of debt and equity used by firms to finance their operations.

Supposing that firms seek to maximize value, is there a capital structure that will maximize the value of the firm or, in equivalent terms, minimize its cost of capital? This question was one of the first corporate finance topics formally studied by economists. Decades of research have yielded many helpful insights, but, as we will see, some mysteries remain.

The reading begins with brief descriptions of debt and equity securities aimed at highlighting fundamental differences between them. The differences are important, which suggests that the choice of capital structure should be, too. Next we describe a few of the ways to measure leverage and observe its effects on financial statements and common metrics of shareholders’ returns. This discussion likewise suggests that capital structure must matter somehow. To understand how leverage matters, we begin by establishing the conditions under which it does not matter. The seminal propositions set forth by Modigliani and Miller (M&M) in the 1950s showed that, given perfect capital markets, the value of the firm is independent of its capital structure. Under the conditions set forth by M&M, the value of the firm is entirely determined by its operations and not at all by how it is capitalized. M&M’s basic insight is important not only for understanding determinants of optimal capital structure but also for other corporate financial policies. For example, the same idea can be used to formulate conditions under which dividend policy or risk management policies are irrelevant to firm value. M&M demonstrated that any theory of optimal capital structure must rely on violations of one or more of the so-called perfect market conditions. Accordingly, the reading proceeds to relax several of these conditions, one by one, to see what is implied for firm value and hence capital structure choice. The reading concludes with an examination of two more advanced topics—debt overhang and signaling—that underscore the importance of being careful with leverage. Too much leverage is dangerous because it cannot easily be undone: Fixing an overleveraged company may be impossible. Finally, we examine the relatively simple insights gleaned from theory in the messier context of real-world financial management. We see that, although theory cannot fully explain companies’ capital structure choices, it nevertheless adds to our understanding of them.

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2 ESSENTIAL READING 2.1 Characteristics of Debt and Equity Securities Capital structure at the most basic level refers to a company’s mix of two basic types of securities: debt and equity, which differ in fundamental ways. To focus on the key issues involved in capital structure choice, we consider simple debt and equity contracts, ignoring for the moment many real-world features of each, as well as so-called hybrid securities that combine features of both.a

2.1.1 Debt A debt contract is a promise by the borrower (the firm) to repay an amount borrowed from the lender on a certain future date and to pay a specified amount of interest per period until that date. In exchange for this promise, the lender (the investor) gives the loan proceeds—typically an amount of cash—to the borrower. Any of these fundamental terms—the amount borrowed, the interest rate, and the maturity date— may be constant or variable over the life of the agreement. An example of a loan with a variable principal amount is a revolving line of credit, of which the borrower may use more or less as business activity fluctuates. Such a loan may also bear a variable amount of interest—a floating rate—that goes up or down with fluctuations in some other quoted market interest rate. Debt is often described as a fixed claim, meaning its terms are fixed by contract, and usually the amount owed by the borrower at any given point is a fixed amount of currency that does not depend on how well or how poorly the borrower’s business is performing. When a company is unable to meet its obligations to lenders, it is said to be in default. This brings into play the other key attribute of debt, priority, which refers to the lenders’ right to be paid before shareholders. When a company defaults on its debts, it may be liquidated; that is, its assets may be sold to raise cash to pay lenders, or some assets may simply be handed over to lenders. In this situation, the lenders have a legal right to be paid before shareholders receive anything. These two fundamental

a

Preferred stock and convertible bonds are two types of hybrid securities. Preferred stock usually promises a contractually fixed dividend that has priority (or preference) over common dividends, and preferred shares get paid before common shares in the event of liquidation. Convertible bonds give a bondholder the right to convert his or her bond into shares of stock of the issuer at a future date at a specified price per share (or number of shares per bond). The right to convert the bond is valuable, which means the investors must pay a higher price for such a bond or, more conventionally, accept a lower interest rate than on an otherwise identical nonconvertible issue. It also means that convertible bonds behave more like bonds at certain times and more like stock at other times, depending on investors’ views and the value of the conversion rights.

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characteristics of debt—contractually fixed terms and priority in liquidation— distinguish it from equity. Debt obligations have other common features as well. For example, the borrower may agree to additional conditions or requirements, known as covenants, that restrict the borrower’s total amount of borrowing or impose other financial conditions. Other common restrictions that might be imposed by covenants concern minimum cash and working capital balances to ensure that the company maintains adequate liquidity to meet its cash flow needs and repayment obligations. Or the borrower may agree to secure a loan with collateral—specific assets that the lender may attach or claim in the event of nonpayment. Debt contracts also typically specify seniority—the order in which different lenders receive preference regarding repayment in the event of liquidation. (Readers wishing for a more in-depth discussion of debt may want to study Core Reading: Introduction to Bonds and Bond Math [HBP No. 5170]).

2.1.2 Equity Once obligations to lenders have been fulfilled, a company’s remaining assets and/or cash flow belong to equity, i.e., its shareholders,b who have the residual claim on the firm’s assets. In effect, shareholders get the leftovers after lenders’ claims are satisfied. As a result, cash flows to shareholders are much more uncertain than are cash flows to lenders. Whether a company prospers because of superior operations or simply good luck, the benefit beyond its debt obligations accrues to shareholders. Conversely, if a company stumbles or is simply unlucky, the shareholders suffer, assuming lenders can still be repaid. The other key feature of equity is control. Shareholders elect the board of directors, which in turn selects and appoints top management, sets corporate strategy, evaluates and rewards management, and approves substantial transactions such as mergers and acquisitions. Shareholders may also participate directly in major decisions of the company by voting to approve (or not) large transactions such as a merger or restructuring. By contrast, lenders have little or no control of the firm, beyond the covenants mentioned above, unless the firm defaults on its debt obligations. The fundamental contrast, then, is that debt is a fixed claim with little or no control rights, and equity is a residual claim with nearly all control rights. From an investor’s point of view, the fixed nature of the debt claim, plus its priority, makes it a less risky investment than an equity claim issued by the same firm.

b

We use the terms equity holders, shareholders, and stockholders interchangeably because all refer to the investors in a company’s equity (stock).

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2.2 Measuring Leverage When the only claims that a firm may issue are debt and equity, the term leverage simply reflects the extent to which a company finances its operations with debt: More debt corresponds to greater leverage, all else being equal. Sometimes we say that when a company issues debt, it “levers” its equity (the latter may be referred to as levered equity) or its operations. Leverage is sometimes referred to as gearing, a nod to the notion of mechanical gears (e.g., in an automobile or bicycle) that increase the distance traveled for a given number of rotations of a drive shaft or set of pedals. There are many ways to measure or quantify degrees of leverage using financial ratios. Perhaps the most common are balance sheet ratios that compare directly, or implicitly, an amount of debt to an amount of equity. Examples include Debt/Equity and Debt/Capital. In the latter ratio, capital simply equals debt plus equity. Debt and equity may be measured using book (accounting) values taken from the borrower’s financial statements, or they can be measured using market values taken from price of the borrower’s traded debt and equity securities. Consider, for example, a firm whose balance sheet shows total debt of $1,000 and equity of $5,000. Its book-value Debt/Equity ratio equals 0.20 (= $1,000/$5,000) and Debt/Capital equals 0.17 (= $1,000/($1,000 + $5,000)). Either may be used to measure the firm’s leverage and compare it to other firms, for example, or to its own historical ratios. Suppose the same firm’s debt and equity securities are traded and that the market value of the debt equals its book value of $1,000, but the market value of its equity (number of shares outstanding times market price per share) is $7,500. On a marketvalue basis, the firm’s Debt/Equity ratio is lower—0.13 rather than 0.20—and so is its Debt/Capital ratio—0.12 rather than 0.17. Which is correct: book- or market-value based measures? In the real world, analysts and executives use both. Many debt covenants are written in terms of book values, which are readily available and auditable, but analysts clearly care about market values as well, which may better reflect economic reality. Other common measures of leverage combine an item from the firm’s income statement with one from its balance sheet. For example, Debt/EBITDA (earnings before interest, taxes, depreciation, and amortization) compares the amount of debt outstanding at a point in time to a measure of cash flow from operations over a period of time. This ratio compares debt not to equity but rather to a measure of the firm’s ability to service the debt, namely, its pretax operating cash flow (all else being equal, one expects EBITDA to be positively related to equity). Finally, some financial ratios compare a borrower’s ability to generate profit or cash flow to its obligations to make periodic cash payments of interest and/or principal. An example of an interest coverage ratio is EBITDA/Interest, which compares operating

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cash flow to interest. A company generating $500 of EBITDA and facing concurrent interest obligations of $100 has its interest “covered” five times by its cash flow. Higher interest coverage is associated with a lower (or safer) degree of leverage, all else being equal.

2.3 The Financial Effects of Leverage

2.3.1 The Effect of Leverage on Measures of Financial Performance Increasing leverage, however it is measured, affects other parts of a firm’s financial statements and common metrics of financial performance. It is important to understand these effects to understand the degree to which differences in two firms’ return on equity, for example, may be explained by differences in their capital structures as opposed to differences in their operating performance. Interactive Illustration 1 allows you to observe the impact of leverage on the financial performance of two simple hypothetical companies with identical operations but different capital structures. INTERACTIVE ILLUSTRATION 1 Effect of Leverage on EPS and ROE Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2IVa2hz

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The interactive illustration shows the operating results for two companies, each with a book value of $1,000. The unlevered company (“Unlevered Capital Structure”) has no debt; it is capitalized with 100% equity, which is represented by 20 shares of stock. In other words, it has unlevered equity. The levered firm (“Levered Capital Structure”) is capitalized with a combination of debt and equity. Both companies generate earnings before interest and taxes (EBIT) of $100 and are identical in all other respects. The interactive illustration opens with debt equal to zero for the levered company so both companies are, in effect, unlevered. Both have return on equity (ROE) of 10% and earnings per share (EPS) of $5.00. (You can toggle between ROE and EPS using the switch under the chart on the right.) Now move the slider for debt level to $300. The unlevered firm remains unchanged, but the levered firm now has debt of $300 and equity of $700 represented by 14 shares of stock (values for debt and equity are accounting, or book, values). The debt carries an annual interest rate of 4%. How does it affect the company’s financial performance? Both companies have EBIT during the year of $100, but the levered company has to pay interest of $12. Accordingly, the levered company’s net income is lower: $88 compared to the unlevered company’s $100. Are the levered company’s stockholders unhappy about this reduction in net income? Not necessarily. Its net income of $88 implies a higher return on equity ($88/$700 = 12.6%) than does the unlevered firm’s $100 (its ROE is $100/$1,000 = 10.0%). The levered firm has higher ROE than the otherwise identical unlevered firm, and this is generally the case: Leverage raises ROE, all else being equal. Additionally, the levered firm also has higher EPS, computed as each firm’s net income divided by its number of shares. The levered company’s stockholders earn $6.29 per share compared to the unlevered firm’s $5.00 per share. We may say that the initial $100 of EBIT has been “levered” by the debt in the levered company’s capital structure; that is, the increased ROE and EPS are due solely to its use of leverage. The levered company’s shareholders should like this result, assuming that the firm does well. But leverage amplifies the pain of poor results as well. Suppose, instead of a profit, each firm suffers an operating loss: Move the EBIT slider to −$100. Now the levered firm’s pretax loss exceeds that of the unlevered firm’s: −$112 compared to −$100 (assuming the levered firm is still able to pay its interest of $12). The levered firm’s ROE is −16% compared to only −10% for the unlevered firm. And its EPS is also significantly worse (−$8.00 versus −$5.00). Now return the EBIT slider to $100 and increase the levered firm’s debt level further, to $500. Once again the levered firm has lower net income but higher ROE and EPS, exactly the result we saw above. Move the EBIT slider from one extreme value to the other and observe the general result: Leverage amplifies both the highs and the lows of a business’s performance, and the higher the leverage, the greater the amplification.

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2.3.2 The Effect of Leverage on Risk Another way to understand the effect of leverage is to examine its effect on the allocation of business risk. Think of a given firm as being subject to a certain amount of business risk, depending on all sorts of industry- and firm-specific factors. All of the business risk—however much it amounts to—must be borne by the firm’s owners. If the firm is all equity, then the shareholders clearly bear all the risk. What if the firm is partly debt financed? The equity holders still bear all the risk. Why? Because they are the residual claimants. Put differently, when the firm issues debt—think of a small amount, at first—it is creating a relatively “safe” claim. It is safe because, as we have seen, payments to lenders are stipulated by contract; they don’t depend on whether operating results are strong or weak, assuming no default (and if there is a default, debt has priority over equity). A debt claim is the safest security the firm can offer investors. As a result, lenders bear little, if any, of the firm’s business risk. If the lenders do not bear it, then the equity holders must still bear all of it. Except now there is less equity because some of it has been displaced in the capital structure by debt. Therefore the amount of risk borne per dollar of equity must rise as debt (leverage) rises. INTERACTIVE ILLUSTRATION 2 Effect of Leverage on the Allocation of Risk Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2upC3e0

Interactive Illustration 2 animates the reallocation of business risk that accompanies a change in capital structure (leverage). The illustration depicts a single firm whose business risk is represented by red dots, 60 in all. The firm’s capital is represented by the dollar bills at the bottom of the illustration. To begin, there are five units of capital (the dollar bills), and all are equity, so the 60 units of risk are distributed evenly, 12 dots per 5187 | Core Reading: CAPITAL STRUCTURE THEORY

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bill. Now move the slider one unit to the right, which changes the capital structure by substituting one unit of debt for one unit of equity (the dollar bill representing debt turns red). The total amount of capital is the same and so is the total amount of business risk, but the risk is reallocated—it is distributed evenly over all four units of equity, now 15 dots per bill, and none is borne by the debt. The levered equity is riskier (15 dots per bill) than the unlevered equity (12 dots per bill) because, even though total capital and total risk are the same, the proportions of debt and equity have changed. Move the slider farther to the right and observe the reallocation of risk that accompanies each increase in leverage: The number of dots goes from 15 per bill to 20 to 30 until, at the extreme level of 80% debt, all 60 dots are piled up on the single unit of equity. Not only did equity become riskier with each substitution of debt for equity, but the risk per unit of equity rose at an increasing rate, from 12 to 15 to 20 to 30 to 60 dots per unit of equity. The more “safe” debt claims that a firm decides to issue, the riskier the remaining equity becomes. But at some point, the debt starts getting risky, too. This reality was not incorporated in the simple example just examined. In other words, if a firm issues too many “safe” claims, they are no longer very safe. Indeed, in the limit, issuing 100% debt claims is identical, from the perspective of the allocation of business risk, to issuing 100% equity. What happens when “safe” debt claims are no longer safe is a very important topic, but we will defer it for now. Instead, we return to the problem of choosing proportions of debt and equity when the chance of default is relatively small. We saw the effect of leverage on ROE and EPS. We have seen that equity is riskier than debt, and that leverage amplifies business risk from the perspective of equity holders. This should matter—investors certainly care about risk—but how? The key question is whether equity holders are fairly compensated for the extra risk they bear when leverage rises. The fact that ROE and EPS rise when debt replaces equity sounds helpful—equity holders bear more risk but they also get higher ROE and EPS. But that isn’t enough to determine whether leverage makes shareholders better or worse off. Presumably, because they control the firm, shareholders will cause it to adopt a capital structure—a mix of debt and equity—that maximizes their own wealth. Hence, to understand capital structure choice, we must examine the effect of corporate leverage on shareholders’ wealth—not solely on the firm’s financial statements. In a wide range of settings, shareholder wealth is maximized when firm value is maximized. So the question becomes, “What capital structure maximizes the value of the firm?” The first economists to address this question meaningfully were Franco Modigliani and Merton Miller.

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2.4 Modigliani and Miller Proposition I: Capital Structure Irrelevance and Firm Value

In a famous paper published in 1958,1 Modigliani and Miller (M&M) revolutionized corporate finance with their Proposition I: M&M Proposition I: Under certain conditions, the proportion of debt and equity in a firm’s capital structure has no effect on its value. In somewhat different words, M&M showed that, given perfect capital markets, the value of the firm depends only on the value of the cash flow it produces. Yet another way to say this is that the value of the firm is determined by the left-hand side of the balance sheet—by its real, value-creating operations—not by the right-hand side—that is, by which types of securities it decides to issue. In this context value expressly means market value, not book or accounting value; M&M are not interested in accounting rules but rather how capital structure affects the wealth of the firm’s owners. The conditions required for Proposition I to hold (“M&M conditions”) are also sometimes referred to as perfect capital markets. What are “perfect” capital markets? More than one financial economist has suggested that “perfect markets” should simply be defined as whatever conditions are required for M&M’s Proposition I to hold. Different textbook authors state the M&M conditions somewhat differently, but broadly they include the following: • No taxes • No costs of financial distress • Everyone has the same information • Everyone has equal access to borrowing and lending opportunities • The firm’s operations are invariant with respect to leverage • Capital market equilibrium; specifically, no arbitrage opportunities

Some of these can be modified or stated somewhat differently and Proposition I will still hold. And some arguably have less to do with capital markets than with firms (the invariance of operations) or with governments (no taxes). These issues do not concern us. Rather, we will begin by showing why Proposition I holds. Then we will present M&M’s closely related Proposition II. Finally we will see why the M&M result is so important. It is not because the M&M conditions hold; most manifestly do not. Rather, any valid theory of optimal capital structure must proceed from the violation of one or 5187 | Core Reading: CAPITAL STRUCTURE THEORY

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more of the M&M conditions. In other words, if we wish to argue that capital structure does indeed matter, we must be prepared to say which M&M conditions are being violated. Understanding violations of specific M&M conditions is essential to understanding how a firm’s value is affected by its capital structure.

2.4.1 Financing with 100% Equity Start with an all-equity firm whose value is denoted as VU (the subscript “U” stands for “unlevered”). Consider a single period, one year. The firm’s business is risky; to represent this risk as simply as possible, suppose the company’s operations will produce cash flows of either $1,300 or $900, with equal likelihood, to be received one year from now. These two future states of the world—call them “good” and “bad”—are the only possible outcomes. The risk-adjusted discount rate for the firm’s operations is 10%.c Therefore the present value (PV) of the firm’s cash flows (and hence, of its assets) is $1,000:

PV(50% ⋅ $1,300 + 50% ⋅ $900) =

$1,100 = $1,000 (1 + 10%)

Thus, an investor with $1,000 in cash can buy the firm in its entirety. The value of the unlevered firm, VU, must equal the value of its equity, EU. Put differently, the market value of its operations (on the left side of its balance sheet), VU, must equal the market value of all the claims it has issued (the right side of the balance sheet).

PV of all cash flows = $1,000 VU = EU = $1,000 The projected cash flows and expected returns for the $1,000 investment are summarized in Exhibit 1. EXHIBIT 1 Projected Cash Flows and Expected Returns for an All-Equity Firm Projected Cash Flows Initial Investment $1,000

c

Good State $1,300

Bad State $900

Average $1,100

Expected Returns Good State 30.0%

Bad State

Average

−10.0%

10.0%

This is sometimes referred to as the firm’s cost of capital. For more on this topic, please refer to Core Reading: The Cost of Capital (HBP No. 8293).

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2.4.2 Financing with Debt and Equity Now consider another firm with identical operations but with a levered capital structure. The levered firm borrows $500 for one year at a rate of 5%. The rest of its capital is equity. What is the value of the levered equity? We know the market value of the levered firm’s operations, VL, must equal the sum of the market values of its debt and equity, DL and EL , respectively:

VL = EL + DL What is VL, the value of the levered firm? The present value of its future cash flows is $1,000, the same as the unlevered firm. So the present value of the levered firm’s (identical) operations, VL, must also equal $1,000. Then the value of levered equity is simply the difference between VL and DL:

EL = VL − DL = $1,000 − $500 = $500 The market value of levered equity today, EL, is $500. What are the returns to levered equity? EXHIBIT 2 Projected Cash Flows and Expected Returns for a Levered Firm Projected Cash Flows Initial Value

Good

Bad

Average

Expected Returns Good

Bad

Average

Debt

$500

$525

$525

$525

5%

5%

5%

Levered equity

$500

$775

$375

$575

55%

−25%

15%

$1,000

$1,300

$900

$1,100

30%

−10%

10%

Total

As shown in Exhibit 2, the future operating cash flows will (still) be either $1,300 or $900, with equal likelihood. In either future state, debt holders will receive $525, equal to $500 plus 5% interest payable one year from now. Shareholders will receive the remainder of either $775 or $375. Therefore, the returns to levered equity will be either 55% or −25%:

Good: Return to EL =

Bad: Return to EL =

$775 − $500 = 55% $500

$375 − $500 = − 25% $500

The average, or expected, return to levered equity will be 15%.

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What have we shown? As expected, debt is less risky than equity: Lenders are paid all they are owed in both the good and bad states (the debt in this example is riskless). We also demonstrated that levered equity is riskier than unlevered equity. Unlevered equity has state-dependent returns of 30% and −10% in the good and bad states, respectively, for an expected (average) return of 10%. In contrast, levered equity has higher highs and lower lows, just as we saw above. Its state-dependent returns are 55% and −25%. The expected return on the levered equity is 15%, higher than the 10% expected return on unlevered equity, again as shown above. Finally, the weighted average return on the levered firm’s securities, both debt and equity, is 0.5 · 5% + 0.5 · 15% = 10%. This is the same as the return on unlevered equity. This makes sense because we could imagine a single investor owning all of the debt and equity of the levered firm; he or she would be in exactly the same economic position as another investor owning all of the unlevered firm’s equity. All of this proceeded from an assertion that VL = VU = $1,000, which allowed us to infer the value of the levered firm’s equity: EL = $500. This certainly is consistent with M&M’s Proposition I, but it doesn’t prove it. To prove it, we need to explore what happens if VL does not equal VU. In other words, what if EL ≠ $500?

2.4.3 Arbitrage and Firm Value Let’s maintain all the assumptions from above but now suppose that EL = $550 instead of $500; in other words, investors can buy or sell stock in the levered firm for a market price of $550 rather than $500. The operating cash flows in the good and bad states are the same for both the levered and the unlevered firms, and the risk-free rate of interest is still 5%. The equity of the unlevered firm, EU, also is traded and its market price is still $1,000. What should a savvy investor do? Buy securities that are underpriced or fairly priced, and sell securities that are overpriced or fairly priced (at least one part of a savvy transaction will involve an over- or underpriced security). In this case, we suspect the equity of the levered firm, EL, is overpriced at $550, so a savvy investor should be selling it. Specifically, suppose the investor borrows $500 at 5% and takes $500 of his or her own money to buy all the shares of the unlevered firm at the market price of $1,000. This creates a set of payoffs one year later that is identical to those for the levered firm’s equity. To see this, note that the investor bought all of the unlevered firm’s equity, so she or he will have cash flow of $1,300 in the good state and $900 in the bad state. In both states, she or he will owe lenders $525 (to repay the $500 loan plus 5% interest). This leaves cash flow of $775 in the good state and $375 in the bad state, which is identical to the payoffs for the levered equity, EL. (It is essential that the payoffs be replicated for each possible future state, not merely on average.) This is summarized in Exhibit 3, in which the savvy investor borrows $500 at 5% in addition to investing $500 of her or his own funds to buy the unlevered firm for a price of $1,000. In other words, 5187 | Core Reading: CAPITAL STRUCTURE THEORY

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the investor was able to create levered equity on his or her own. By borrowing $500 herself or himself instead of having the firm borrow, the investor has used homemade leverage in place of corporate leverage. EXHIBIT 3 Homemade Leverage Projected Cash Flows Initial Value

Good

Bad

Average

Expected Returns Good

Bad

Average

$1,000

$1,300

$900

$1,100

30%

−10%

10%

Savvy investor’s debt

$500

−!525

−!525

−!525

5%

5%

5%

Homemade levered equity

$500

$775

$375

$575

55%

−25%

15%

Purchased unlevered equity

Having thus created a claim identical in every state to levered equity, what can our savvy investor sell it for? The market price of levered equity, EL, equal to $550! Proceeds from the sale are enough to repay the savvy investor’s own investment of $500, with $50 left over (recall that our calculations already paid lenders the $525 of principal and interest they are owed). The leftover $50 is free! How long did this take? It was instantaneous. Even though the operating cash flows happen a year from now, and the lender gets paid a year from now, and so on, our investor earns his or her $50 profit today. Such a transaction is called arbitrage: the creation of an instantaneous, riskless profit, usually by simultaneously buying and selling the same asset at different prices. Recall that one of the M&M conditions is “no arbitrage.” We have just shown that if the price of the levered equity is $550 instead of $500, there exists an opportunity for arbitrage—free money, which violates a key M&M condition. The same line of argument shows that any price for EL other than $500 gives rise to arbitrage opportunities. In a well-functioning (to say nothing of a perfect) capital market, arbitrage should not exist. Why? Because everyone loves free money. As people execute trades to exploit the arbitrage opportunity, prices quickly adjust (in this example the price of EL will fall) until the opportunity disappears. Another way to state M&M’s no arbitrage condition is to say that we assume that the law of one price (LOOP ) holds for securities. LOOP states that if two assets are identical (they have identical payoffs in all possible future states of the world) then they must have identical prices. In markets for goods and services, LOOP doesn’t always hold—one can sometimes find the same television set or pair of jeans offered at different prices at different stores or websites, for example. But in capital markets, genuine arbitrage opportunities are fairly rare, and getting rarer in today’s markets with high-speed, electronic and computer-directed trading of securities. The no-arbitrage condition underlying M&M’s Proposition I is powerful precisely because the notion of capital market equilibrium that it embodies is so simple—no free money. Indeed, of all the real-world imperfections 5187 | Core Reading: CAPITAL STRUCTURE THEORY

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that lead to violations of the M&M conditions, most pertain to the other conditions, not to “no arbitrage.” The basic logic we used to exploit the mispricing of the levered equity in the example above holds generally. That is, we could make different assumptions about possible future cash flows, the number of possible future states of the world, the probability of each state, the risk-free rate of interest, and so forth. It would not matter: M&M’s Proposition I would still hold as long as the stated M&M conditions are satisfied. Let’s return for a moment to our example of a “wrong” EL price of $550. How did we know which transactions to undertake to exploit the arbitrage opportunity? Very simply, the tactic is to buy whichever security seems too cheap and/or sell any security that seems too expensive. In our example, EU was cheap relative to EL (i.e., EU was fairly priced and EL was overpriced), so we were buying the former and selling the latter. The borrowing we did was done at a fair price of 5%. Another way to grasp the irrelevance result of Proposition I (that capital structure is irrelevant to firm value) is to realize that the transaction that the savvy investor executed involved borrowing at the investor level rather than at the corporate level. The investor was able to replicate the shares of the levered company by borrowing herself or himself. This shows that, under M&M conditions, there is no need for the corporation to borrow. If investors want levered equity, they can easily create it themselves, so why should corporate leverage create any value? It shouldn’t. If so-called homemade or investor-created leverage works just as well as corporate leverage, it makes sense that corporate leverage would be irrelevant to firm value. Interactive Illustration 3 uses homemade leverage to manufacture whatever security is required to exploit the arbitrage opportunity associated with any levered equity price EL that violates M&M Proposition I.

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INTERACTIVE ILLUSTRATION 3 Arbitrage and Homemade Leverage Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2IV9WXf

The interactive illustration generalizes the example we just discussed. It is organized as a sequence of charts that proceeds through the transactions required to exploit mispricing of EL by using homemade leverage. To use it, begin by noting that the assumptions and initial settings are the same as in the example above, except that you must type in a “wrong” value of EL. Type in $550 for EL to review the transaction we just examined. The illustration goes through the steps that a savvy investor would take to exploit the arbitrage opportunity. In step 1, he or she sets up a special company (called Arbco) with a blank balance sheet. Next (in step 2), Arbco borrows $500 at 5% interest. The investor contributes $500 in cash to Arbco (step 3) in exchange for which he or she owns all of Arbco’s equity. Step 3 also shows Arbco now has total capital of $1,000. In step 4, Arbco uses its cash of $1,000 to purchase the equity in the unlevered firm. Step 5 is simply a demonstration that the future payoffs on Arbco’s stock are identical to the payoffs for the levered firm (compare the rows of each table inside the orange boxes: Arbco equity above and the levered firm’s equity below). This demonstrates how the savvy investor has manufactured shares in the levered firm using shares of the unlevered firm and homemade leverage as raw materials. All that remains, then, is for the investor to sell his or her shares of Arbco. This is shown in step 6, which also calculates the arbitrage profit: It cost the investor $500 to create the Arbco equity but he or she can sell it for $550 (the assumed market price of EL) so the riskless profit equals $50. Click Reset in the illustration and try inputting a different value of EL, say, $600. This also violates Proposition I. Review steps 1 through 5 in the illustration to see that almost 5187 | Core Reading: CAPITAL STRUCTURE THEORY

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nothing changes: Arbco is still capitalized with $500 debt and $500 equity and still purchases the equity of the unlevered firm for $1,000. The only difference is that the Arbco equity now may be sold in step 6 for $600 instead of $550, and the arbitrage profit is $100 instead of $50. Now input a value for EL that is less than $500, say, $450. What changes? Homemade leverage (now lending, rather than borrowing) is still used to exploit the arbitrage opportunity, but now the levered firm’s equity is underpriced. Arbco can earn an instantaneous profit by buying the (cheap) levered equity for $450, replicating the returns of the unlevered firm, and then selling the synthetically created unlevered equity for the market price of $1,000. Walk through the steps in the interactive illustration. The investor contributes $950 in cash to capitalize Arbco, in exchange for which he or she owns all the Arbco equity (step 2). It uses its $950 cash in two ways: It buys the equity in the levered firm for the market price of $450 (step 3) and lends the remaining $500 at 5% interest (step 4; this is the same as putting $500 in the bank and letting it earn interest for a year). Step 5 shows that the Arbco equity now has the same payoffs as the equity in the unlevered firm. Therefore, it can be sold for VU = $1,000 in step 6. In effect, the investor used homemade (un)leverage to manufacture unlevered equity at a cost of $950. That is, Arbco is simply lending instead of borrowing. Again, the tactic involves buying relatively underpriced securities and selling relatively overpriced ones. Try other values for EL in interactive illustration 3 to make sure you understand how the arbitrage is identified and exploited. You should also understand how other assumptions might be changed (EBIT, state probabilities, interest rates, etc.) without affecting the fundamental result that Proposition I must hold when all of the M&M conditions hold.

2.5 Modigliani and Miller Proposition II: The Effect of Leverage on the Cost of Capital

M&M’s Proposition I tells us that leverage is irrelevant to firm value. Proposition II concerns the effect of leverage on a firm’s cost of equity capital. In fact, Proposition II follows from Proposition I. Proposition II tells us how leverage must affect the cost of equity in order for Proposition I to hold: M&M Proposition II: The cost of equity for a levered firm rises with its market value debt-to-equity ratio, leaving the weighted average of its costs of debt and equity unchanged.

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Proposition II requires us to shift our perspective from the value of the firm to the expected return on the firm’s assets (i.e., its cost of capital ).d Because, under M&M conditions, a company’s borrowing decisions have no effect on the value of its assets (A), we can infer that leverage must have no effect on rA, the expected return on the firm’s assets. We can use this fact to derive an expression for r E, the expected return on levered equity, which equals its cost of equity. (Similarly, we define the firm’s cost of debt as the expected return on the debt it has issued.) Because the value of the firm is determined by the value of its assets, regardless of how it is capitalized, we know that the value of the firm’s assets, denoted as A, must equal the value of all of its securities, D + E, and this must be so for both the levered and unlevered firms. Therefore:

A = EU = DL + EL Assume that a single investor holds all of a levered firm’s debt and equity, and is therefore entitled to receive all of its operating income. The expected return on a portfolio of securities equals the value-weighted average of the expected returns for each element of the portfolio. In this case, our investor owns a portfolio composed of the levered firm’s debt and equity, each with expected returns of r D and r E, respectively. So we can state the investor’s expected return as follows in equation (1):

rA =

D E rD + rE D+E D+E

(1)

In other words, the expected return on the firm’s assets is equal to the expected returns on its debt and equity, each in proportion to their percentage of the firm’s total assets. Equation (1) is the same formula we use to calculate a firm’s weighted average cost of capital (WACC). We can use it to solve for the return on levered equity, r E, and obtain the following expression:

rE = rA +

D (rA − rD ) E

(2)

Equation (2) is M&M’s Proposition II, which states that the expected return on levered equity increases as the firm’s market-value Debt/Equity ratio (D/E) rises. This is what we expect: As leverage rises, so must the expected return on equity, to compensate equity holders for the increased risk they bear. But we also invoked Proposition I to show that the expected return on equity rises by just the right amount to keep the overall (weighted average) cost of capital, which must equal rA, constant. As the portion of the d

When conditions of market equilibrium exist (i.e., no arbitrage), we may use the terms expected return on firm assets and cost of capital interchangeably.

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firm capitalized with debt increases, the greater weight placed on lower-cost debt relative to higher-cost equity leaves the overall cost of capital unchanged. Stated another way, under M&M conditions, leverage increases the cost of levered equity, rE, but not the cost of capital, rA. Exhibit 4 shows the calculation of the cost of equity capital (equal to the expected return on equity and denoted now as E(r E)) for two simple companies, A and B, with different capital structures. To make the example forward-looking, we base our calculations on expected EBIT (E(EBIT)) of $100, and omit taxes (because M&M assume no taxes).e E(r E) is computed as expected net income/equity for both firms: 10% for unlevered Company A and 15% for levered Company B. Company B’s higher cost of equity is due solely to its higher leverage. EXHIBIT 4 The Expected Return on Equity for Unlevered and Levered Firms Company A Unlevered E (EBIT)

Company B Levered

$100

$100

$0

$25

$100

$75

$0

$500

Equity (E)

$1,000

$500

Total D + E

$1,000

$1,000

Less: Interest expense Net income Debt (D)

E(rE)

10.0%

15.0%

Proposition II (equation (2)) gives exactly this result. Recall that the interest rate on debt, rD, in this example was 5%. The expected return on assets, rA, for the all-equity (unlevered) firm is 10%. Therefore:

rE = rA +

D (rA − rD ) E

rE = 10% +

$500 ⋅ (10% − 5%) = 15% $500

The cost of levered equity, r E = 15%, is exactly the same as shown in Exhibit 4.

e

Given M&M’s perfect capital markets, EBIT represents all the cash flow that the firm can pay to its capital providers, whether lenders or shareholders; that is, all of EBIT goes to either lenders or shareholders because none goes to the government in the form of taxes and none leaks out to anyone else as, for example, costs of financial distress.

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We can also show that the overall cost of capital, rA, is unchanged by the addition of leverage, as required by Proposition I. Equation (1) gives:

rA =

D E rD + rE D+E D+E

rA =

$500 $500 ⋅ 5% + ⋅ 15% = 10% $1,000 $1,000

Finally, the substance of Proposition II can be shown graphically, as in Exhibit 5. As the firm’s debt to equity ratio increases (i.e., as leverage increases), the cost of capital remains constant per Proposition I (the horizontal line). What happens to the cost of equity? We know the cost of equity rises because equity becomes riskier as leverage increases. Proposition II tells us by how much the cost of equity rises. What about the cost of debt? So long as leverage is low enough that there is no chance of default, the cost of debt remains constant. Eventually, leverage is high enough that debt holders begin to bear some of the firm’s business risk because in some states of the world they are not paid in full. Accordingly, at higher leverage ratios, the expected return on debt rises which reduces the rate of increase in the cost of equity. f EXHIBIT 5 The Cost of Debt and Equity as a Function of Leverage

f

Why does the cost of debt rise in Exhibit 5, even though M&M conditions stipulate “no costs of financial distress?” Because as leverage rises, the risk of default increases, in which case lenders are not repaid in full. To protect themselves, lenders demand higher returns and the cost of debt rises. This is so even when there are no costs of financial distress. We will explicitly differentiate between costs of financial distress and default risk further below.

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2.6 Relaxing M&M Conditions: The Static Trade-off Model

The M&M propositions are the logical starting point for any discussion of optimal capital structure because they tell us under what conditions capital structure does not matter. Any theory purporting to show that capital structure does matter must incorporate violations of one or more of the M&M conditions. Perhaps the simplest theory of optimal capital structure comes from relaxing two conditions that obviously do not characterize the real world: no taxes, and no costs of financial distress.

2.6.1 Taxes In a world with taxes, leverage can reduce a company’s taxes. The less a company pays to the government in taxes, the more it retains for the benefit of its owners. Specifically, when interest is deductible but dividends are not, a company can increase its value by substituting tax-deductible interest (payments to lenders) for non-tax-deductible dividends (payments to shareholders), that is, by increasing its leverage. Let’s revisit unlevered Company A and levered Company B once again. Their operating results are shown in Exhibit 6. EXHIBIT 6 Interest Tax Shield for the Levered Firm Company A Unlevered EBIT

Company B Levered

$100

$100

$0

$25

$100

$75

Less: Taxes @ 35%

$35

$26

Net income

$65

$49

Less: Interest expense Pretax income

EBIT for levered Company B is reduced by interest expense ($25) prior to calculating the tax liability. As a result, B’s pretax income of $75 is lower than Company A’s ($100). However, B’s tax expense is only $26 compared to $35 for A. The difference of $9 is an interest tax shield, that is, a reduction in the levered firm’s tax bill. It arises because interest expense is tax deductible, which is valuable provided a company has sufficient taxable income. More generally, the tax shield per period is given by:

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Tax shield = Drt where D = the face amount of the debtg r = the interest rate on the debt t = the corporate tax rate

Interest tax shields increase the cash flow available for payment to the firm’s owners. Further, a firm that maintains its leverage permanently will receive the benefit of interest tax shields not only in the current year but also in every subsequent year in perpetuity. As a result, the value of a levered firm is equal to the value of an identical unlevered firm plus the present value of all future interest tax shields: VL = VU + PV (tax shields) And if the tax shield is a perpetuity, then:

PV(tax shields) =

tax shields Drt = = Dt r r

Substituting, we have VL = VU + Dt

(3)

In other words, the value of a levered firm exceeds the value of an identical unlevered firm by the amount of debt it carries times its tax rate: Dt. Exhibit 7 shows this result graphically. The value of the firm increases as leverage rises, and the increment to firm value is proportional to the amount of debt in the capital structure.

g

Earlier we defined D as the market value of debt; we are now effectively assuming the market value of debt is equal to its face value.

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EXHIBIT 7 Value of the Firm with Tax Shields

What does this imply for the optimal capital structure? That more debt is always better: The optimal Debt/Capital ratio is 100%. Common sense tells us this is unreasonable—real firms don’t use that much debt. There are potential costs associated with issuing debt besides the promised interest payments. Firms with a heavy debt load are more likely to default, which should be costly. To incorporate this idea into a model of optimal capital structure, we need to relax another of the M&M conditions: no costs of financial distress.

2.6.2 Costs of Financial Distress Formally, costs of financial distress (CFD) denote value lost or destroyed by conflicts between claimants when a firm defaults, or is even near to defaulting, on its obligations. We say that a firm is financially distressed when the firm itself or the parties with whom it does business—customers, suppliers, employees, lenders, etc.—feel that it may not be able to meet all of its financial obligations. When a firm cannot meet its obligations, someone will get less than they expected or were promised. Consequently, people begin to take actions to protect themselves: Customers may seek another vendor, suppliers may demand cash on delivery, lenders may move to seize collateral, key employees may leave to join more financially secure firms, and so forth. Such actions harm the firm— they reduce its value—and they may well worsen the firm’s predicament, touching off a downward spiral that destroys the firm fairly quickly. It is important to distinguish between the ordinary costs of a business downturn and costs of financial distress. Even an unlevered firm can suffer a business setback and experience a loss of customers, reduced margins, tightened supply terms and loss of key staff. Costs of financial distress refer to additional costs encountered solely because the firm is levered. In other words, CFD denote costs that an unlevered firm would not 5187 | Core Reading: CAPITAL STRUCTURE THEORY

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encounter, even in a downturn. The M&M no-cost-of-financial-distress condition does not suppose that the firm or its investors cannot lose money, or that the probability of default is zero. Rather, it merely assumes a levered firm is no more harmed by a downturn than an unlevered firm; we might alternatively say that M&M assume that a firm in distress can be restructured with no incremental loss of value. Financial economists sometimes distinguish between direct and indirect costs of financial distress (though M&M require no such distinction). Direct costs include expenses such as fees charged by the attorneys, lenders, and advisers typically involved in debt restructurings and/or bankruptcy proceedings. Indirect costs include other negative consequences for the company’s operations: the loss of customers and/or employees, tarnishing of the company’s brand, and costly distractions imposed on management. Indirect costs are typically much harder to measure with precision, but both types matter. To incorporate costs of financial distress in a model of optimal capital structure, we need both to relate them to leverage and to describe their effect on firm value. At the time a firm borrows, CFD is a contingent rather than an actual cost, so it helps to think about CFD in terms of its probability. To simplify, let’s think of distress as a discrete event that either happens or not at a given point, with probability pdistress . Then the expected costs of distress, denoted by E(CFD), equal the cost of distress when it occurs multiplied by the probability that distress will occur. Even though distress is a future contingent event, the possibility of distress affects value immediately, as soon as the firm borrows. The effect on firm value is simply the present value of the expected value of the costs of financial distress, denoted as PV[CFD ∙ pdistress]. Even this oversimplified representation of CFD has practical implications because managers may understand its two elements—CFD and pdistress —separately and address them using different tools. One obvious determinant of the probability of distress is the degree of leverage. Specifically, we expect a positive relationship between them: Raising leverage should increase the likelihood of distress. Measures of leverage such as debt-tocapital ratios and coverage ratios are widely monitored by lenders and credit rating agencies, partly as a way to estimate the likelihood of distress. The costs of distress, on the other hand, are affected by other factors. These include the nature of the firm’s assets—whether they are hard assets such as land or machinery that could be sold by a distressed firm without much loss of value, or soft assets such as scientific know-how that may walk out the door, so to speak, in the midst of distress and be lost entirely. For example, a firm with soft assets and a high cost of distress can reduce its PV(CFD)h by reducing the probability of distress, most likely by keeping its leverage very low. Other factors that plausibly affect the cost of distress include some of

h

To simplify notation, we will let PV(CFD) denote PV(E(CFD)) = PV(CFD ∙ pdistress) in the rest of this reading.

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the characteristics of the debt: whether it is publicly or privately held, and whether by a few lenders or many, for example. It is likely to be less costly to renegotiate or restructure debt that is privately held by a small number of lenders because it is easier to find them and communicate with them—to get them all in one room, in effect—and it is likely easier for them to agree among themselves if they are few in number. Such is not the case when the company’s debt is publicly held (widely dispersed) or even when there are many private lenders involved.

2.6.3 The Static Trade-off Model To complete a model of optimal capital structure that includes costs of financial distress, we need to describe the relationship between PV(CFD) and leverage; that is, PV(CFD) = f (leverage), but what does this function look like? Because many costs of financial distress are not easily measured, it is difficult to observe the relationship using real-world data. Nonetheless it is widely believed that the relationship is positive and convex. That is, PV(CFD) increases with a company’s debt level, and at an increasing rate. See Exhibit 8. EXHIBIT 8 PV(CFD) Is a Convex Function of the Amount of Debt

Now we can combine the tax benefits of leverage, from equation (3), with the distress-related cost of leverage to express the value of a levered firm:

VL = VU + Dt − PV(CFD)

(4)

This simple expression says that the value of the levered firm equals the value of the unlevered firm plus the value of interest tax shields (here, in perpetuity) less the present value of the costs of financial distress. This is known as the static trade-off model of optimal capital structure because the optimal capital structure represents a trade-off

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between costs and benefits of leverage. For most firms, the optimum is typically some combination of debt and equity, but not 100% of either. As debt increases in Exhibit 9, the value of the levered firm rises at a constant rate: the slope of the straight line is t, the corporate tax rate. However, even as tax shields raise the value of the firm, costs of financial distress lower it. The curve in Exhibit 9 shows this trade-off, with an optimum at the curve’s highest point. The optimum occurs at the point where the marginal benefit of tax shields equals the marginal cost from PV(CFD). We also recognize now the importance of the nonlinearity in PV(CFD). As debt increases, PV(CFD) rises at an increasing rate. This guarantees that PV(CFD) will overwhelm the value of tax shields before debt reaches 100% of the capital structure. Because of the convexity of PV(CFD), it is possible to get an interior optimum rather than a corner solution—that is, an optimum between the extreme values of 100% debt or 100% equity.i EXHIBIT 9 The Static Trade-off Model of Optimal Debt Structure

The static trade-off model implies that, for most firms, it is better to have some debt rather than none—but not so much that it jeopardizes the firm’s financial health. The model is appealing because it conforms nicely to managers’ intuition that taxes and distress should both matter, and it is qualitatively consistent with the real-world i

Readers may wonder about the possibility of negative leverage (a firm’s excess cash exceeds its total debt: it is a net lender rather than a net borrower) in the context of the static trade-off model. While negative leverage is indeed possible, it cannot be optimal in a model narrowly concerned with taxes and CFD. CFD, as we have defined them, must be zero when leverage is negative, so tax shields are the only consideration. Negative debt actually creates anti-tax shields because it increases rather reduces total taxes, because interest income on the excess cash increases corporate taxable income (compared to an unlevered firm).

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observation that most firms use some debt but try not to use too much. In surveys of corporate CFOs and CEOs, most report that their firms do indeed have a target amount of leverage (or a target range), expressed in terms of a Debt/Capital ratio, coverage ratio, or credit rating.2 This, too, is consistent with the static trade-off model. Interactive Illustration 4 presents a visual representation of the static trade-off model of optimal capital structure. You can adjust inputs for the two main elements, tax shields and costs of financial distress, and observe the effect on the optimal amount of debt. To begin, leave the tax rate at its initial setting of 30% and focus on CFD. There are two controls for CFD: One changes the “average” amount by which CFD rises over the range of debt level, the other adjusts the shape of this curve. Manipulate each of these to get a sense of how they affect the graph on the right of the illustration showing CFD as a function of debt. Regardless of the settings chosen, CFD always increases with debt and at an increasing rate, qualitatively similar to Exhibit 9. The graph on the left incorporates both the (linear) effect of tax shields on firm value and the (nonlinear) effect of PV(CFD). An increase in the tax rate increases the optimal amount of leverage (the peak of the firm-value curve moves to the right) because higher tax rates make the tax shield provided by leverage more valuable. Conversely, increases in the costs of financial distress move the optimum to the left—to lower amounts of leverage. INTERACTIVE ILLUSTRATION 4 Optimal Capital Structure Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pNvc9F

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Despite its appealing properties, the static trade-off model has some shortcomings, which we note briefly. • The model is more descriptive than prescriptive. That is, while it says that an

optimum exists, it doesn’t help us actually locate it for a real firm, chiefly because we cannot estimate expected costs of financial distress with precision or confidence. • There are some obvious inconsistencies between the model’s predictions and

real-world firm behavior. Some firms use substantial amounts of debt despite having little or no need for tax shields (some airline companies, for example), which suggests that there are other benefits from leverage besides tax shields. We also observe a significant number of firms eschewing debt altogether, despite having large tax liabilities that could be reduced and no apparent danger of financial distress. This suggests there are other disadvantages associated with leverage besides costs of financial distress. • Similarly, the model predicts changes in capital structure when, for example, tax

rates change significantly. For the most part, historical changes in corporate leverage following significant tax rate changes have not been consistent with the model’s predictions. • Finally, the model (at least the simple version presented here) ignores personal

and other investor taxes. These would be relevant if, for example, the tax advantage of debt at the corporate level was somehow offset by a disadvantage at the investor tax level, that is, if the government recouped lost corporate tax revenue because investors paid higher taxes on income from holding corporate debt securities. The static trade-off model can be adapted to incorporate investor taxes, but such models are difficult to parameterize. In addition, versions with reasonable parameters still suffer from the shortcomings just mentioned. Not surprisingly, there are other theories about capital structure. We will mention a few of them and describe them qualitatively. But lest we leave readers more disappointed than impressed with the static trade-off model, a few summary points should be made. First, there is a general consensus that, in most developed economies, there is indeed a net tax advantage to corporate borrowing, although experts disagree about how large it is. In addition, companies themselves are well aware of the corporate tax burden and most manage it actively (although capital structure choice is far from the only tool at their disposal). In short, taxes certainly matter, and leverage tends to reduce them. Similarly, costs of financial distress are quite real and important, even if we are not good at quantifying them and, once again, the static trade-off model gets the basic idea right: Leverage raises the risk of default, which increases PV(CFD). The model is helpful even though we may say it is neither fully descriptive nor fully prescriptive.

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2.7 Relaxing Other M&M Conditions

2.7.1 Agency Costs Agency costs refer to costs that arise when there is a separation between ownership and control. Think of a large firm managed by professionals who are necessarily different people from the investors who own the firms’ securities. In such a situation, the firm’s managers may make different decisions than the actual owners would if the latter had the ability to do so. Some of the differences may be innocuous, but some may benefit the managers at the expense of the owners. Owners can and do watch the firm, engage outside professionals to audit the firm, perhaps even fire the managers, and so forth. But all such protective measures are costly. Agency costs include both the value lost because managers are not acting entirely in the best interest of the owners and the costs incurred by owners to monitor and limit managers’ ability to engage in such value transfers. The M&M condition violated by the introduction of such agency costs is, “The firm’s operations are invariant with respect to leverage.” In fact, the nature and size of agency costs may be affected by the firm’s capital structure. A widely shared view among financial economists is that, when leverage is low, it may be easier for management to indulge in wasteful spending and empire building, for example, than when leverage is high because higher leverage creates greater pressure to perform in order to generate the cash required to service debt. Such costs are often referred to as agency costs of equity because they arise from having “too much” equity and not enough debt. We might alternatively refer to them as agency benefits of debt. In this view, increasing a firm’s debt raises its value by both the incremental tax shields and by marginal improvements in the firm’s performance due to better management. There also are agency costs associated with debt, however. That is, when leverage is high, managers’ decisions may diverge from owners’ best interests in other ways. Think of a levered firm in which managers worried about default slavishly conserve cash to reduce debt (and preserve their jobs), even to the point of underinvesting: foregoing projects that would increase the value of the firm but that consume cash in the short run. Another quite different problem arises when the firm is distressed, and both shareholders and managers have an incentive to take risky gambles—to “roll the dice”— even investing in dubious projects because doing so gives them at least a glimmer of hope that they might get lucky. Such behavior is often referred to as risk shifting, because shareholders and managers embrace risky projects at the expense of overall firm value and contrary to the interests of the lenders. The costs of underinvestment and risk shifting are both examples of what may be referred to as agency costs of debt. Agency costs of debt are reduced when debt is reduced.

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Leverage-related agency costs fit logically into the trade-off framework introduced above in equations (3) and (4). We can update the static trade-off theory of capital structure by including the present values of additional costs and benefits: VL = VU + PV(tax shields) − PV(CFD) + PV(agency benefits of debt) − PV(agency costs of debt) This makes sense conceptually. At low levels of debt, the incremental value of adding a dollar of debt is now higher than t, the tax rate, because the firm gets both tax shields and the marginal agency benefits of debt. As debt rises higher, agency costs of debt eventually exceed agency benefits of debt, and the net marginal cost of leverage is even greater than suggested by marginal costs of financial distress in the basic static trade-off model. Unfortunately, the implied optimum target leverage is now even harder to locate. There are at least three elements in the updated trade-off that cannot be readily quantified: costs of financial distress, the agency costs of debt, and the agency benefits of debt. Some of the qualitative predictions of agency theory are consistent with real-world managerial and firm behavior, and some are plausible explanations for some of the gap between observed firm behavior and predictions of the basic static trade-off model. But even thus augmented, the trade-off theory still doesn’t explain all of what we observe in the real world.

2.7.2 Asymmetric Information and Pecking Order Theory Next we examine the effect of relaxing yet another M&M condition, namely, “Everyone has the same information set.” A particular violation of this condition, known by economists as asymmetric information, has interesting implications for capital structure. It occurs when insiders (think of the firm’s top managers) know more than outsiders (e.g., investors in the firm’s public equity) about the firm, and outsiders know this is the case. Outsiders are still willing to hold the equity, which may, after all, perform very well. But now suppose the firm proposes to raise additional capital by issuing new securities to external investors. The firm’s choice of which type of security to issue—debt or equity—may reveal something about top management’s private information. For concreteness, suppose the firm’s stock price is $50 per share, and it announces that it wants to raise new capital by issuing new equity shares. Prospective equity investors say to themselves, in effect, “They know more than I do about the firm; if they are willing to sell stock at $50, that must be a good deal for them. So $50 per share must be too high a price.” Such investors will not be willing to buy new shares at $50 precisely because better informed insiders are willing to sell at $50. Even the existing shares will no longer trade at $50 but at some lower price. The announcement by the firm of its intention to sell stock causes the current stock price to drop, even though the new

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shares have not been issued yet. In effect, announcing a stock issue reveals at least some of management’s private information about the value of the stock. This is an example of the more general phenomenon of adverse selection, which occurs when a more informed party uses its superior information to take advantage of a less informed party in a commercial transaction. Health insurance companies worry, for example, that after they set the price of an insurance policy based on the average health of a target population of consumers, sicker people will choose to buy it and healthier people will not, in which case the policy will have been mispriced. Returning to the case of corporations issuing securities, suppose that our hypothetical company announces it will issue new debt rather than equity. Investors reason similarly: “They know more than I do; if they are issuing debt instead of equity, it must be because they know $50 is too low a stock price,” or “They must be optimistic about the future or they wouldn’t be willing to borrow more.” Accordingly, the stock price rises when the company announces its plan to borrow. The stock price reaction to the company’s announcement of which funding option—debt or equity—it will pursue is attributed to signaling: It is interpreted by the market as revealing, or “signaling,” some of the insiders’ private information about the firm—information that by assumption has not yet been incorporated into the stock price. When information is clearly asymmetric and a transaction could indeed exploit insiders’ information advantage, the phenomenon of adverse selection may make a transaction involving equity impossible at any price. In effect, uninformed parties refuse to transact with informed parties and the market literally disappears. For most companies, this problem is much less severe and the outcome less extreme. It is not always clear that a significant asymmetry exists, and there may be plausible justifications for a particular announcement that have nothing to do with private information or adverse selection. What happens when there might be an asymmetry and the company might be trying to exploit it? Investors protect themselves by “charging” more for external capital—they offer a lower price for securities to compensate themselves, on average, for the possibility of adverse selection. This last point implies that raising external capital is more expensive in the presence of asymmetric information than it would be otherwise, even if the corporation has no intention of exploiting its information advantage. It cannot convince investors, without some cost, that it has no private information. And if it does have such information, it still may be best for the investors that the firm not reveal it. For example, the information may concern trade secrets that cannot be revealed to investors without also being revealed to competitors, which could be more damaging than the cost of adverse selection. What are the implications for capital structure choice? When insiders know more than outsiders, the cost of raising external capital goes up, perhaps by a lot. As a result,

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internal sources of funds (e.g., cash on hand) are preferred over external sources. When internal funds are insufficient to meet the firm’s financing needs, the firm minimizes the costs of adverse selection by issuing securities that are less affected by it. How is this done? By issuing the most senior, least risky claims possible—senior secured debt,j for example. Recall that investors who are worried about adverse selection demand a higher expected return to protect themselves. This is less of a concern with a senior security (safe debt) than a junior security (risky equity). The safe debt promises a fixed payment at a fixed date regardless of whether future results are strong or weak. Accordingly, its value doesn’t depend much, if at all, on insiders’ private information about operations. Because private information matters little to the value of such securities, investors need less protection from adverse selection. The foregoing suggests that companies follow a pecking order, or hierarchy, of financing preferences when they raise capital. Most preferred is internal financing: retained earnings, in effect. Next is senior secured debt, followed by senior unsecured debt, then subordinated debt, and so forth, all the way down the right side of the balance sheet to the riskiest security of all: external equity. By observing this pecking order, a company minimizes the effect of adverse selection on its cost of capital. The implications of asymmetric information for capital structure choice are strikingly different from those of the static trade-off theory examined above. • Unlike trade-off models, the pecking order hypothesis implies no optimal target

amount of leverage. Firms minimize the cost of capital simply by raising funds as cheaply as possible as the need arises. • The announcement of an equity issue should cause a negative stock price

reaction; the more severe the information asymmetry, the more negative the reaction. • Companies facing more severe asymmetries may actually forego a value-creating

project if undertaking it requires raising external equity. That is, they will appear to be underinvesting, even though their decisions may be value-maximizing, given the information asymmetry. To cope with information asymmetry, a company may maintain internal slack— excess cash, apparently unneeded for operations, or other sources of liquidity—to ensure their ability to fund a strategy or a large project without needing to raise external capital. The trade-off model(s) and the pecking order hypothesis are sometimes compared as though they are competing theories. They do indeed have different implications, and

j

That is, debt that ranks highest in priority of repayment and is secured by the value of underlying assets in the event of default.

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some of these may be examined in light of real-world data. But we shouldn’t expect empirical testing to suggest that one theory is right and the other wrong. They arise, after all, from relaxing different M&M conditions, and both have useful things to say about capital structure choice.

2.7.3 Product Market Models Other ideas about capital structure may become relevant if we relax further M&M’s condition regarding the invariance of the firm’s operations with respect to leverage. That is, if we allow that leverage may affect operations for reasons other than agency costs. We can imagine ways in which a company’s capital structure choice has spillover effects on its product market positions, either directly or indirectly, through the threats and opportunities it faces. We can label such possibilities as product market models. Some are complex and involve game theory. But their spirit is this: Beyond the obvious problem of how to raise capital and allocate control, capital structure may help a firm defend and exploit a profitable product market position by deterring competitors or would-be competitors. Imagine, for example, a company that is a market leader and highly profitable in part because of its market power: the ability to charge higher prices than it would if the firm had more or stronger competitors. This market leader naturally wishes to defend its market share. It is concerned about possible entry and wants to let potential competitors know that it will respond swiftly and aggressively by lowering prices if anyone enters. Price wars erode operating margins, so the market leader’s implicit threat is not credible if it cannot afford lower margins for an extended period of time. To boost the credibility of the threat, our market leader may maintain a large war chest—low leverage and ample cash on hand—in excess of what either static trade-off or pecking order models would otherwise suggest. The problem with such stories is not that they are implausible or inconsistent with value-maximization (though some may be) but that they tend to be very case-specific and/or ad hoc. They are difficult to generalize in ways that are helpful and prescriptive, and difficult to specify in ways that lead to testable hypotheses.

3 SUPPLEMENTAL READING 3.1 Resetting Capital Structure So far we’ve considered capital structure as though it is solely the result of one or more internal decisions—about what target to set, which securities to issue, and so forth. However, external factors also play a role, in particular by changing a company’s 5187 | Core Reading: CAPITAL STRUCTURE THEORY

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leverage after it has been set. Consider, for example, an extended rise in the stock market that lifts share prices. As equity values increase, leverage declines, possibly to a suboptimal level. This problem is easy to fix—companies have only to issue debt to repurchase shares or pay a dividend, thereby restoring leverage to target levels. A more difficult problem arises when unexpected events substantially reduce asset values and consequently raise leverage. Once leverage has become “too high,” it can be very difficult to restore it to a reasonable—to say nothing of an optimal—level. The seemingly logical transaction in which the firm issues new equity to pay down debt may not in fact be optimal for everyone involved, and it may be difficult or impossible to execute. To see why, we examine two common problems encountered by overleveraged firms—debt overhang and signaling.

3.1.1 Debt Overhang The term debt overhang refers to the situation in which firms are unable or unwilling to issue new equity (or other junior securities, such as preferred stock) because of the riskiness of their existing debt. For similar reasons, management may also be unwilling to undertake a value-creating project—one that would effectively reduce leverage by increasing the value of the firm—if doing so requires issuing new equity. Consider a firm that has become over-levered and wants to reduce its debt. Reducing debt lowers the probability of default and hence reduces the present value of costs of financial distress, which in turn raises firm value. So far so good. However, if the only way to reduce debt is to issue new equity, the firm may well decline to do so. Why? Because the increase in firm value disproportionately benefits the firm’s lenders compared to its shareholders. The value of lenders’ debt claims will rise as the firm reduces its leverage because their risky debt will become less risky. If the lenders are disproportionate “winners,” who loses? The equity holders. In effect, reducing leverage may indeed raise firm value, but it also redistributes value from stockholders to lenders so that stockholders are actually worse off. Stockholders control the firm, so they simply decline to undertake a reduction in leverage that makes lenders better off at their own expense. For concreteness, here is a simple numerical example. Consider Company X, which is worth $100 today. One year from now, Company X will be worth either $50 or $150 with equal likelihood (ignore discounting to keep the numbers simple). See Exhibit 10. EXHIBIT 10 Value of Company X in Good and Bad States

Company X’s value in one year Probability

Bad State

Good State

$50

$150

50%

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Now, to make it over-levered, suppose Company X has outstanding debt with a face value of $90, due in one year. It is easy to compute the values of Company X’s debt and equity in the good and bad states and, hence, the expected value of each. See Exhibit 11. EXHIBIT 11 Expected Value of Company X Bad State

Good State

Expected Value

Company X’s value in one year

$50

$150

$100

Debt value in one year

$50

$90

$70

Equity value in one year

$0

$60

$30

In the good state, lenders are paid in full ($90) with $60 left over for equity. In the bad state, lenders receive only $50 and stockholders get nothing. The expected value of the debt is therefore $70, and the expected value of the equity is $30, giving a total of $100, which equals the present value of Company X because we are ignoring discounting. (Technically, we haven’t proven that Company X is over-levered, but we have shown that its debt is worth significantly less than face value [$70 < $90], which is sufficient for our example.) Now suppose Company X wants to reduce its leverage and has decided to issue new equity to raise cash of $30, which it will simply hold on its balance sheet. Let’s revisit the values of debt and equity in the good and bad states. See Exhibit 12. EXHIBIT 12 Revised Values of Company X’s Debt and Equity Bad State

Good State

Expected Value

Company X’s value in one year

$80

$180

$100 + $30 = $130

Debt value in one year

$80

$90

$85

Equity value in one year

$0

$90

$45

The value of the firm increases by the amount of cash raised ($30) in both the good and bad states, to $180 and $80, respectively. Lenders now receive $80 in the bad state— including all of the cash raised by the sale of stock—still leaving the shareholders with zero in that state. In the good state, lenders are repaid in full ($90) and the shareholders also receive $90. The present value of the debt has risen by $15 and so has the present value of the equity, for a total of $30. Everyone is better off, it would appear, and debt and equity holders have evenly split the $30 increase in firm value. So in what sense has debt benefitted disproportionately? We can begin to see the problem by noting that lenders are now better off by $30 in the bad state, while shareholders receive no benefit in the bad state.

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At the same time, note that the stock now has a value of $45. But it was already worth $30 before the new equity was issued, and now it is divided among both old and new shareholders. Put differently, we had equity worth $30, issued more equity for another $30, but the stock is not worth $30 + $30 = $60; rather, it is worth only $45. Where is the missing $15? It went to the lenders, whose claim was worth $70 but is now worth $85, much closer to the face value of $90. The shareholders clearly are the losers. But which shareholders—old or new? It must be the old shareholders who lose; new shareholders would not participate if they stood to lose immediately upon buying the shares. In fact, when old shareholders first announce the plan to issue equity, the stock price falls and the debt price rises, even before the deal has been done. In effect, shareholders have just announced a generous plan to bail out lenders whose claims are worth less than face value. This is good news for bond prices but must be bad news for the stock. Recall, though, that the old shareholders control the firm. Once they understand it, they will decline to play this game. They can simply refuse to lower Company X’s leverage. Reducing leverage is not value maximizing for them, even if it benefits the firm as a whole. So a seemingly straightforward approach to reducing leverage is in fact untenable. More broadly, the problem of debt overhang illustrates an important aspect of financial distress: a built-in conflict of interest between shareholders and lenders. When there is plenty of value for everyone, debt and equity interests need not collide. But distress is, by definition, a state in which there is not enough value to satisfy all claims. Someone has to lose, and investors—whether lenders or shareholders—naturally prefer it not be themselves. In this situation, actions taken by one group of claimants in pursuit of their own interests may well harm another. A dramatic real-world example of debt overhang and associated problems occurred in the global banking industry during the 2008–2009 financial crisis. To oversimplify, many banks held substantial portfolios of US subprime mortgages. The value of those assets collapsed when US housing prices fell. As a result, banks were over-levered: Their assets were suddenly worth a lot less and did not adequately support preexisting levels of debt. With inadequate equity, banks could not make new loans. The sudden unavailability of credit hurt all kinds of businesses—especially those with problems such as an urgent need to roll over commercial paper or refinance maturing debt—and contributed to a severe recession with many harmful side effects, such as high unemployment. It was clear that banks needed more equity capital, but debt overhang, among other problems, meant that the banks could not simply issue more equity. Doing so would have helped the banks’ creditors but would have harmed equity values, exactly the opposite of the desired result. And in any case, the banks’ shareholders were not likely to support such a cure. Addressing banks’ shortage of equity required extraordinary interventions by governments and central banks, such as emergency loans, loan- and asset-value guarantees, and asset purchases.

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Debt overhang is one of the serious possible consequences of overleverage. Next we examine a second factor, asymmetric information, and we will see that it, too, has particular implications for firms that find themselves over-levered.

3.1.2 Asymmetric Information and Signaling Earlier in the reading, we saw that information asymmetries affect both investors’ willingness to trade securities and the prices at which transactions take place. We saw that asymmetric information creates a pecking order of preferences for raising capital and hence affects firms’ capital structures. These ideas clearly apply when a company is over-levered. When a company is in or near financial distress, a natural asymmetry arises: Investors want to know, “How bad is it?” and they assume management knows more than they do. That is, even if there were little or no asymmetry of information concerning the firm’s unlevered assets, there will certainly be an asymmetry concerning its distress. However serious the company’s financial situation as described by management, investors fear things are actually worse: “If they admit it’s actually that bad, it must be twice that bad.” We know that such investors will not purchase equity except at discounted prices, and perhaps not at all. The pecking order hypothesis tells us that external equity is most subject to the problem of adverse selection—it is at the bottom of the pecking order. And yet this is the very security that would most help an over-levered company fix its capital structure. For this reason, asymmetric information is almost always relevant in financial distress, even in industries and companies that are otherwise well understood by outside investors.

3.1.3 Implications of Debt Overhang and Signaling for Capital Structure Choice External events can cause even well-managed companies to become over- or underlevered compared to whatever target they consider optimal. While underleverage is an easy problem to address, overleverage is generally much harder—if not impossible—to fix. The obvious proposed solution of issuing equity to pay down debt is certain to be expensive and may even be impossible because of the problems of debt overhang and asymmetric information just discussed. What are the practical implications? For firms setting a target capital structure based solely on the static trade-off model’s primary considerations of tax benefits versus costs of financial distress, the implied target is likely too high. Costs of financial distress, as traditionally defined, do not reflect the adjustment costs of trying to reduce leverage once it is too high. The implication: Be careful levering up. A prudent financial manager may want to undershoot his or her firm’s target leverage ratio to reduce the likelihood that some external shock will cause the firm to become over-levered. Put another way, the costs of resetting a suboptimal capital structure are asymmetric: It is much easier 5187 | Core Reading: CAPITAL STRUCTURE THEORY

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and cheaper to adjust leverage up than down, so managers may want to err on the side of less leverage.

3.2 Practice and Complexity

This reading has focused primarily on theory: M&M propositions and some of the insights and models obtained by relaxing one or more of the M&M conditions. Armed with insights from theory, we can examine data on corporate capital structures or put ourselves in the shoes of an executive faced with setting policy. Either way we are confronted immediately with complexity. Our models don’t fully describe the real world as we observe it, nor do they lead, by themselves, to an obvious policy prescription for a given real firm or even a hypothetical typical firm. So we will conclude with comments about why this might be so and why it shouldn’t surprise us. Real companies, especially large ones, formulate numerous financial policies jointly. A firm’s capital structure is set in conjunction with its dividend and payout policies, risk management policies, tax planning activities, capital planning and budgeting processes, and so forth. These must make sense as a set of policies affecting the firm as a whole; any one of them may appear suboptimal when viewed in isolation. In contrast, theory naturally starts with a narrow focus: We hold everything else constant and ask what combination of debt and equity maximizes the value of the firm. But not everything else is constant, and capital structure is not the only financial policy to be set. Firms must cope with trade-offs and the messiness of real-world data that is in part an artifact of the different choices that firms make given the trade-offs confronting them. Put differently, a particular capital structure choice may appear to be suboptimal viewed in isolation, but it actually may make sense within the larger set of financial policies, to say nothing of the much broader context of whole-firm optimization—the entire constellation of financial and nonfinancial policies. Even if we focus on a single issue—taxes, for example—the real world is much more complex than the simple single-rate tax system we examined. Our theory posited that debt augments firm value by reducing taxes and that excess cash (negative debt) does the opposite—it creates an anti-tax shield and actually increases taxes to the detriment of shareholders. Both are useful insights. In reality, though, the excess cash held by some US firms is trapped in other countries by complex US tax laws. For some companies, trapped cash balances are a side effect produced by the combination of global operations and specific provisions of US tax law; for others, it may be the result of deliberate tax minimization strategies. Regardless of its origins, repatriating cash to the United States, whether for corporate use or distribution to shareholders, triggers large US tax liabilities. Companies avoid the tax liability by simply leaving the cash abroad. In

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short, a large stockpile of cash may not be suboptimal even viewed from a narrow, purely tax-oriented perspective. Another reality for many companies is that the problem of optimizing leverage is dynamic rather than static. A simple illustration is a leveraged buyout (LBO) transaction. Sponsors of the LBO buy a business in a deal financed primarily with debt; at closing, the subject company’s leverage ratio is high by any measure. But the plan is to pay down the debt quickly and deliberately, reducing leverage by as much as half within a few years, at which point the buyout sponsors plan to sell their interest and move on to the next deal. A hallmark of LBOs is high leverage at closing but for the purpose of facilitating a transfer of ownership and concentrating control (i.e., equity) in the hands of one or a few owners, who swiftly introduce changes in the firm’s operations. In such situations, the target leverage ratio is a moving target, and is entirely consistent with the aims of both borrower and lender. Changes in capital structure are programmed and are not mere accidents in which shocks such as a recession move a company off a static target. Regardless of transactions such as LBOs, many companies have what may be called life cycles—a predictable ordering of stages that a company passes through, from early to late or younger to older, with different financial needs and priorities at each stage along the way. Early in its life, a company may require repeated infusions of capital—it is a net user of capital, and raising funds is a high priority. It may have little profit, or even experience losses, and hence have little need for tax shields. Even so, debt may be attractive if lenders are willing to lend because it avoids dilution of the founding shareholders’ control. In contrast, a mature firm may be self-financing—it generates more cash from operations than it needs to finance its growth and new investment. For such firms, active tax management is a higher priority. And far from scrounging for new external capital, such firms must focus on the best way to return capital to investors, through dividends or share repurchases, for example. Seen in the context of life cycles, long-term capital structure policy is clearly a dynamic rather than a static problem and, once again, the variability in leverage ratios that we observe in real-world data is at least partly an artifact of the changing priorities that characterize different stages in the life cycle. So, to repeat, capital structure choice presents complex problems. How do real companies cope with this complexity? We can learn a bit more by asking executives how they think about them. A fairly recent survey of a large sample of CEOs and CFOs reveals that a majority of large companies do indeed use targets to set capital structures.3 However, the primary target was not a leverage ratio but rather a particular credit rating. Historically, many companies and investors regarded corporate credit ratings as reliable indicators of a company’s degree of access to the debt markets; a company with a high rating—say, investment grade (BBB or higher)—could count on being able to borrow from banks or bond investors whenever it needed to. Companies with lower ratings (the majority of US companies are rated below investment grade) might not 5187 | Core Reading: CAPITAL STRUCTURE THEORY

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always have this luxury. Consequently, a strong company might adopt a firm policy of maintaining an investment grade rating. Such a company will arrange its capitalization, including its leverage ratio, to secure and maintain the desired credit rating. If its leverage and related financial metrics, such as coverage ratios, don’t secure the desired rating, then the leverage, rather than the targeted rating, changes. Once again, the financial crisis of 2008–2009 provides interesting examples. The most creditworthy companies were able to borrow during the crisis (indeed, many took advantage of very low interest rates because central banks around the world slashed interest rates to historically low levels); at the same time, many weaker corporate borrowers lost access to the debt markets altogether—they simply could not borrow at any rate. The second highest priority that executives cited as a determinant of capital structure is a desire to create or maintain flexibility. This is perhaps intuitive and unsurprising, but it is also hard to interpret with precision and probably must be judged subjectively, even by the executives themselves. Maybe it simply means avoiding overleverage and indicates that executives are aware of the costs of financial distress, as well as debt overhang and signaling dangers, and they formulate leverage targets accordingly. But even if we agree on what the word flexibility means, there are alternative ways to create and maintain it. Low leverage is one way; ample liquidity is another; unused standby credit is another; and so forth. So a company with high leverage but ample, unused standby credit facilities may enjoy as much flexibility as a company with lower leverage and no standby credit. The third highest priority cited by surveyed executives is taxes, and it is reassuring to see it high on the list of considerations that affect the choice of capital structure. As we have already mentioned, though, active management of corporate tax liabilities is much more complicated than simply deciding how much to borrow. The complexity surrounding capital structure choice is vexing from the point of view of a theorist: The set of tools that real companies use to manage capital structure, together with the constellation of related policies, is simply too rich to model in detail. On the other hand, many of the tools are used in ways suggesting that companies are preoccupied with a small number of large issues. Surveys of executives bear this out: Three issues frequently cited are maintaining a particular credit rating, maintaining flexibility, and managing taxes. That is not such a long list, and the concerns seem sensible: They tend to validate our theoretical preoccupation with a few such big issues, and this is so even if our theoretical objective—the selection of a unique optimal target leverage ratio—is too narrow.

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4 KEY TERMS agency costs Costs that arise when a principal must rely on a representative, or

agent, to make decisions or take actions on his or her behalf. When the agent’s interests diverge from the principal’s, the latter must incur costs to prevent the agent from taking actions harmful to the principal. arbitrage The simultaneous purchase and sale of the same or identical assets for

different prices, generating an instantaneous riskless profit for the investor. asymmetric information Denotes a difference in the information sets possessed by

insiders (managers and/or large shareholders) compared to outsiders (e.g., nonemployees and small shareholders). capital structure The mix of securities (typically debt and equity) that a company

chooses to finance its operations. cost of capital In the context of this Core Reading, a discount rate, comprised of

both the time value of money and a risk premium appropriate for the risk inherent in a particular project. Under equilibrium conditions, that is, no arbitrage, the cost of capital may also refer to the expected return on firm assets. See also weighted average cost of capital (WACC). cost of debt The expected rate of return required by a firm’s lenders. cost of equity The expected rate of return required by a firm’s shareholders. costs of financial distress (CFD) The direct and indirect costs that arise when a

company is unable to meet all of its obligations. debt contract A contract between a borrower and lender that describes each party’s

obligations to the other, typically including the amount of the loan, interest rate, repayment terms, and related requirements of the borrowing. debt overhang The situation in which firms are unable or unwilling to issue new

equity (or other junior securities, such as preferred stock) because of the riskiness of their existing debt. debt/equity ratio The ratio of the amounts of debt and equity issued by a firm; a

measure of its leverage. The ratio is sometimes computed using book (accounting) values and sometimes using market values of traded securities.

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equity An ownership interest in a company represented by shares of stock; a residual

claim on a firm’s assets after all of its debt obligations have been paid. financial ratios In this context, we refer to ratios commonly used to measure a

company’s leverage and/or its ability to repay debt and cover its interest expense. See also debt/equity ratio. homemade leverage The ability of investors to borrow (lend) assets in order to

manufacture or synthetically create levered (unlevered) equity independent of firm-level financing decisions. interest tax shield The reduction in corporate taxes due to the deductibility of

interest. law of one price (LOOP) A principle of market equilibrium stating that two

identical assets must have the same market price. leverage The proportion of company capital financed by debt. levered equity Refers to the equity capital of a firm whose capital structure contains

both debt and equity. Modigliani and Miller (M&M) propositions M&M Proposition I states that, in a

world of perfect capital markets, a company’s choice of capital structure has no effect on its value. Proposition II states that the cost of equity capital increases in relation to the increase in its debt to equity ratio and thus leaves the overall cost of capital constant. pecking order A hierarchy of funding sources companies may follow as a way to

minimize the costs of adverse selection that arise from asymmetric information. signaling In the context of asymmetric information, signaling occurs when a party

possessing private (superior) information enters one particular transaction rather than some other equally possible transaction. The choice of transaction may reveal (“signal”) some of the knowledgeable party’s private information. static trade-off model A theory of capital structure in which an optimal capital

structure (proportion of debt and equity) is determined by the point at which the marginal cost of financial distress equals the marginal benefit of interest tax shields. weighted average cost of capital (WACC) A weighted average of a company’s

cost of debt and its cost of equity; the weights are proportions of debt and equity (respectively) in the capital structure, wherein both debt and equity are measured as market rather than book (accounting) values.

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5 NOTATION A CFD D DL E

Market value of firm assets Cost of financial distress Market value of debt Market value of debt in a levered firm Market value of equity

EL

Market value of levered equity

EU

Market value of unlevered equity

EBIT EBITDA EPS PV PV(CFD) r

Earnings before interest and taxes Earnings before interest, taxes, depreciation, and amortization Earnings per share Present value Present value of the cost of financial distress interest rate on debt

rA

Expected return on firm assets; cost of capital

rE

Expected return on equity; cost of equity

rD

Expected return on debt; cost of debt

t

Corporate tax rate

VU

Value of the unlevered firm

VL

Value of the levered firm

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6 PRACTICE QUESTIONS Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2GfzJb4

7 ENDNOTES 1 Franco Modigliani and Merton Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 48 (June 1958), 261–297. 2 Henri Servaes and Peter Tufano, “The Theory and Practice of Corporate Capital Structure,” Deutsche Bank Global Markets (January 2006). 3 Henri Servaes and Peter Tufano, “The Theory and Practice of Corporate Capital Structure,” Deutsche Bank Global Markets (January 2006).

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8 INDEX agency benefits of debt, 30 agency costs, description of, 30, 42 agency costs, leverage-related, 31 agency costs of debt, 30 agency costs of equity, 30 arbitrage, description of, 15, 42 arbitrage, opportunities for, 15, 16, 17 asymmetric information, adverse selection and, 32 asymmetric information, description of, 42 asymmetric information, financial distress and, 38 asymmetric information, implications for capital structure choice, 33 asymmetric information, pecking order theory and, 31 asymmetric information, signaling and, 38 capital structure, complexity and choice of, 39, 40, 41 capital structure, costs of financial distress and, 25, 38 capital structure, description of, 3, 4, 42 capital structure, differences in firms’ return on equity and, 7 capital structure, firm value and irrelevance of, 10, 16 capital structure, implications of asymmetric information for, 31, 33, 38 capital structure, life cycles and longterm policy on, 40 capital structure, nature and size of agency costs and, 30 capital structure, reallocation of business risk and, 9 capital structure, resetting, 34 capital structure, static trade-off model of, 26, 27, 28, 30

5187 | Core Reading: CAPITAL STRUCTURE THEORY

capital structure, value of firm and amount of debt in, 23 collateral, 5, 24 control, 5 cost of capital, 3, 19, 41 cost of debt, 19, 21, 41 cost of equity, 18, 20, 42 costs of financial distress (CFD), 24, 28, 43 covenants, 5, 6 coverage ratio, 6, 25, 28, 41 credit rating, 25, 27, 40, 41 Debt/Capital ratio, 6, 24, 28 debt contract, 4, 5, 43 Debt/EBITDA ratio, 6 Debt/Equity ratio, 6, 19, 43 debt overhang, description of, 35, 43 debt overhang, implications for capital structure choice, 38 default, costs of financial distress and, 24 default, possible results of, 4 default, “safe” debt and, 9 direct costs, 25 earnings per share (EPS), effects of leverage on, 7 EBITDA/Interest ratio, 6 equity, agency costs of, 30 equity, description of, 5, 43 equity, levered, 6, 43 financial performance, effect leverage on measures of, 7 financial ratios, 6, 43 fixed claim, 4, 5 homemade leverage, 14, 15, 16, 17, 18, 42

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indirect costs, 25 interest tax shields, 23, 26, 27, 28, 30, 39, 43 law of one price (LOOP), 15, 43 leverage, agency costs related to, 30 leverage, description of, 6, 43 leverage, effect on measures of financial performance, 7 leverage, effect on risk, 9 leverage, measuring, 6 leverage, restoring to target levels, 35 leveraged buyouts (LBOs), 40 levered equity, allocation of risk and, 10 levered equity, debt and equity effects on, 13 levered equity, description of, 6, 42 levered equity, effect of leverage on, 7 Modigliani and Miller (M&M) propositions, description of, 3, 42 Modigliani and Miller (M&M) Proposition I, 11 Modigliani and Miller (M&M) Proposition II, 18

risk shifting, 30 seniority, 5 signaling, asymmetric information and, 37 signaling, description of, 32, 43 signaling, implications for capital structure choice, 38 static trade-off model, description of, 26, 43 static trade-off model, interactive visual representation of, 28 static trade-off model, optimum debt structure and, 27 static trade-off model, shortcomings of, 29 static trade-off model, summary points on benefits of using, 29 static trade-off model, updating with present values of costs and benefits, 31 weighted average cost of capital (WACC), 19, 43

pecking order, 33, 38, 43 perfect capital markets, 11 priority, 4 product market models, 34 residual claim, 5, 9 return on equity (ROE), effects of leverage on, 7 risk, cost of equity related to, 21 risk, debt overhang and, 35 risk, effect of leverage on, 9 risk, expected return on equity and, 19

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