CAPITAL STRUCTURE

* An Institutional Framework for analyzing Capital Structure
- The Benefits of Borrowing
- The Costs of Borrowing

* Tools For Evaluating Capital Structure
1. Cost Of Capital
* What is the cost of capital?

* Minimizing the cost of capital

* Applying the cost of capital approach to evaluate capital structure

2. Relative Analysis

* Proxies for benefits and costs

* Visual scanning and ranking

* Wider crosssectional approaches: Regression

THE COSTS AND THE BENEFITS OF DEBT

* Real Benefits Of Debt:

(a) Tax Benefits: Interest on debt is tax deductible whereas cashflows on equity (like dividends) are not. Consequently the effective cost of debt is the interest cost net of tax benefits. Using some simple notation, assume that r is the interest rate on debt, t is the marginal tax rate on income to the corporation and B is the borrowing. Then the tax benefit each year from borrowing can be written as follows:

Tax benefit each year = t r B

After tax interest rate of debt = (1-t) r

Proposition 1: Other things being equal, the higher the marginal tax rate of a corporation, the more debt it will have in its capital structure.

1. You are comparing the debt ratios of real estate corporations, which pay the corporate tax rate, and real estate investment trusts, which are not taxed, but are required to pay 95% of their earnings as dividends to their stockholders. Which of these two groups would you expect to have the higher debt ratio?
( ) The real estate corporations
( ) The real estate investment trusts

(b) Adds discipline to management: Equity is a cushion; Debt is a sword; The management of firms which have high cashflows left over each year are more likely to be complacent and inefficient. The discipline of debt gives them a greater incentive to shape up. (This is called the 'Free Cashflow Hypothesis')

2. Assume that you buy into this argument that debt adds discipline to management. Which of the following types of companies will most benefit from debt adding this discipline?
( ) Conservatively financed, privately owned businesses
( ) Conservatively financed, publicly traded companies, with a wide and diverse stock holding
( ) Conservatively financed, publicly traded companies, with an activist and primarily institutional holding.

* Real Costs Of Debt

(1) Bankruptcy Cost: The expected bankruptcy cost is a function of two variables--

- the cost of going bankrupt: This cost includes legal and other deadweight costs associated with bankruptcy. This is not highly correlated with the amount of debt. In general, financial distress may create costs for you even before actual bankruptcy in terms of lost sales or other costs. These costs are going to be greater if

(a) you manufacture products that require repairs (Example: Chrysler)

(b) you provide goods or services where quality is an important attribute but is difficult to determine in advance (Example: Airlines)

(c) you manufacture products for which there are switching costs (Example: Computers)

(d) Products whose value to customers depends on the services and complementary products supplied by independent companies. (Example: Software for Computer companies)

- the probability of bankruptcy: The greater the proportion of debt in a firm, the higher will be the probability of bankruptcy. In general the probability of bankruptcy should increase with

(a) the degree of operating leverage, (b) cyclical variations in the industry, (c) competition in the industry, (d) relative price fluctuations of commodities used in the firm and (e) smaller size and less diversification in the firm.

Proposition 2: Other things being equal, the greater the implicit bankruptcy cost and/or probability of bankruptcy in the operating cashflows of the firm, the less debt the firm can afford to use. Hence firms with relatively stable and predictable cashflows can afford to borrow more than firms that have variable and unpredictable cashflows.

3. Rank the following companies on the magnitude of bankruptcy costs from most to least, taking into account both explicit and implicit costs ñ
( ) A Grocery Store
( ) An Airplane Manufacturer
( ) High Technology company

(2) Agency Cost: When a firm borrows money a set of agency problems are created:

(a) The equity investors may promise to take safe projects when they borrow the money but then turn around and take much riskier projects.

(b) The equity investors may use the borrowed money to pay out large dividends to themselves.

When a firm borrows money, it usually attracts a set of covenants that affect its flexibility. This lost flexibility has a cost. The following is a list of covenants usually found in bond agreements.

Proposition 3: Other things being equal, the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use. [Agency problems will be more accentuated if a firm's assets are intangible or if the firm's projects are difficult to monitor]

4. You are a lender, and are concerned about lending to a firm, with substantial growth opportunities and good projects, but also with projects which are difficult to monitor. An investment banker suggests that convertible bonds may be one way of resolving the problem. Explain how.

(3) Loss of future financing flexibility: When a firm borrows upto its capacity, it loses the flexibility of financing future projects with debt. Given the reluctance of firms to issue new stock, this might mean that the firm might have the reject good projects in the future.

Proposition 4: Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects.

A Balance Sheet Format

 Advantages of Borrowing Disadvantages of Borrowing 1. Tax Benefit: Higher tax rates --> Higher tax benefit 1. Bankruptcy Cost: Higher business risk --> Higher Cost 2. Added Discipline: Greater the separation between managers and stockholders --> Greater the benefit 2. Agency Cost: Greater the separation between stock- holders & lenders --> Higher Cost 3. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost

* A Hypothetical Scenario

Assume you operate in an environment, where

(a) there are no taxes

(b) there is no separation between stockholders and managers.

(c) there is no default risk

(d) there is no separation between stockholders and bondholders

(e) firms know their future financing needs with certainty.

* What are the costs of borrowing? the benefits? the optimal debt ratio?

The Miller-Modigliani Theorem

In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant. The value of a firm is independent of its debt ratio.
* Assume now that you relax the tax rate assumption, and leave the other assumptions unchanged. What is the optimal debt ratio then?

* Implications

(a) Leverage is irrelevant. A firm's value will be determined by its project cash flows.

(b) The cost of capital of the firm will not change with leverage. As a firm increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage.

WHAT DO FIRMS LOOK AT IN FINANCING?

A. Is there a financing hierarchy?

* Argument

There are some who argue that firms follow a financing hierarchy, with retained earnings being the most preferred choice for financing, followed by debt and that new equity is the least preferred choice.

* Rationale

Managers value flexibility and control. To the extent that external financing reduces flexibility for future financing (especially if it is debt) and control (Bonds have covenants; New equity attracts new stockholders into the company and may reduce insider holdings as a percentage of total holding), managers prefer retained earnings as a source of capital.

* Preference rankings long-term finance: Results of a survey

Ranking Source Score

1 Retained Earnings 5.61

2 Straight Debt 4.88

3 Convertible Debt 3.02

4 External Common Equity 2.42

5 Straight Preferred Stock 2.22

6 Convertible Preferred 1.72
5. You are reading the Wall Street Journal and notice a tombstone ad for a company, offering to sell convertible preferred stock. What would you hypothesize about the health of the company issuing these securities?
r Nothing
r Healthier than the average firm
r In much more financial trouble than the average firm

What to include in debt

General Rule: Any interest-bearing liability should be included in debt, and hence in the calculation of debt ratios.

* Hybrid Securities: The standard practice in calculating debt ratios has been all or nothing - a security is classified as debt if it has more debt characteritics than equity characteristics, which is itself a subjective judgment. The problem in this approach is that it leads to large shifts in debt ratios, depending upon whether a security is included in debt or not, and sudden changes in years in which a security is converted into equity. A more sensible way of dealing with hybrid securities would be to estimate the debt and equity components separately for hybrid securities and add these components to their respective sides.

* Off-Balance Sheet Commitments: The general rule to follow is to ignore contingent liabilities which hedge against risk, since the obligations on the contingent claim will be offset by benefits elsewhere.

* Leases: The third area of debate is the treatment of leases. While capitalized leases are now shown as part of debt, operating leases are not. Since a fine line separates the two, the conservative approach to estimating debt ratios will capitalize operating leases and show them as part of debt.

* Pensions: Firms generally include in their debt, the excess of accumulated benefit obligation over the pension fund assets. Here again, a conservative estimate of the debt ratio will consider projected benefit obligation over pension fund assets.

* Debt of non-consolidated entities: Firms generally do not have to show as a liability that debt that is owed by their non-consolidated subsidiaries, even though they may have guaranteed and stand liable for that borrowing.

Measuring Financial Leverage

Debt Ratios

Debt ratios attempt to do this, by relating debt to total capital or to equity. The two most widely used debt ratios are -

Debt to Capital Ratio = Debt / (Debt + Equity)

Debt to Equity Ratio = Debt / Equity

The first ratio measures debt as a proportion of the total capital of the firm, and cannot exceed 100%. The second measures debt as a proportion of the book value of equity in the firm, and can be easily derived from the first, since -
Debt/Equity Ratio = (Debt/Capital Ratio)/(1-Debt/Capital Ratio)
a. Variants on Debt Ratios

There are two close variants of these ratios. In the first, only long term debt is used rather than total debt, with the rationale being that short term debt is transitory and will not affect the long term solvency of the firm.

Long-term Debt to Capital Ratio = Debt / (Debt + Equity)

Long-term Debt to Equity Ratio = Debt / Equity

Given the ease with which firms can roll over short term debt, and the willingness of many firms to use short term financing to fund long term projects, these variants can provide a misleading picture of the firm's financial leverage risk.

b. Market Value Ratios

The second variant of these ratios uses market value instead of book value, primarily to reflect the fact that some firms have a significantly greater capacity to borrow than their book values indicate.

Market Value : Debt to Capital Ratio = MV of Debt / (MV of Debt + MV of Equity)

MV Debt to Equity Ratio =MV of Debt / MV of Equity

The Cost Of Capital Approach

* What is the cost of capital?

The cost of capital is a composite cost to the firm of raising financing to fund its projects. It is the discount rate that will be applied to capital budgeting projects within the firm. It will depend upon:

(a) the components of financing: Debt, Equity or Preferred stock

(b) the cost of each component

In summary, the cost of capital is the cost of each component weighted by its importance in the firm's financing decision.

WACC = ke (E/(D+E)) + kd (D/(D+E))

where,

WACC = Weighted Average Cost of Capital

ke = Cost of Equity

kd = After-tax Cost of Debt

E/(D+E), D/(D+E) = Proportions of equity and debt in capital structure.

* Step 1: Calculating the cost of each component

Cost of Debt: The cost of debt is the market interest rate that the firm has to pay on its borrowing. It will depend upon three components-

(a) The general level of interest rates: When interest rates go up, all firms will face a higher cost of debt.

(b) The default premium: This will depend upon the firm's riskiness. The risker the firm, the higher the default premium

(c) The firm's tax rate: Since interest on debt is tax deductible, the only relevant cost of debt is the after tax cost of debt

Cost of debt = kd = Current Borrowing Rate (1 - Tax rate)
The cost of debt is
- the current market interest rate at which the company can issue debt.

- corrected for the tax benefit that one gets for interest
The cost of debt is not
- the interest rate at which the company obtained the debt it has on its books.
Cost of Equity: The Capital Asset pricing model provides us with the basis for making this estimation.

Cost of Equity = Rf + b (E(RM) - Rf)

where,

Rf = Riskfree Rate

b = Beta of the stock

E(RM) = Expected Return on market

Question: What is the cost of using retained earnings? of preferred stock?

The cost of equity is
1. the required rate of return given the risk of the company and interest rates/ risk premiums.
2. inclusive of both dividend yield and price appreciation

6. A recent article in an Asian business magazine argued that equity was cheaper than debt, because dividend yields are much lower than interest rates on debt. Do you agree with this statement
( ) Yes
( ) No

Can equity ever be cheaper than debt?
( ) Yes
( ) No

7. In the same vein, there were many who argued that Japanese companies had low costs of equity in the late 80s, because they issued stock at high Price/Earnings Ratios. Do you agree with this statement?
( ) Yes
( ) No

* Step 2: Calculate the weights of each component
Rule 1: Use the average and not the marginal proportions of debt and equity. (For example, if a company has 40% equity and 60% debt overall, and is considering a new project is financed entirely with debt the appropriate weights are 40-60 and not 0-100%.)

Why? An Example

Assume company has an optimal debt ratio of 50% and is currently at the optimal (\$500 million debt, \$500 million equity). The cost of equity is 15% and the after-tax cost of debt is 5%.

Firm's WACC = 15% (50%) + 5% (50%) = 10%

Project A: Requires \$100 million; Financed with 100% Debt; Has an IRR of 9%.

Project Specific WACC = 5%

Project B: Also requires \$100 million; Financed with 100% Equity; Has an IRR of 12%.

Project Specific WACC = 12%

* Which project would you accept/reject using project-specific WACC? Does your decision make sense?

* Which project would you accept using the firm's WACC?

Rule 2: Always use the market weights of equity, preferred stock and debt for constructing the weights. Book values are often misleading and outdated.

Market value of equity = Number of shares outstanding * current share price
Market value of debt = The market value of debt will depend upon the maturity of the bonds, the coupon rate and the current market interest rate.
(If the maturities and coupon rates are unclear use book values)

Fallacies about book and market value:

1. People will not lend on the basis of market value.

2. Book Value is more reliable than Market Value because it does not change as much.
8. Many CFOs argue that using book value is more conservative than using market value, because the market value of equity is usually much higher than book value. Is this statement true, from a cost of capital perspective? (Will you get a more conservative estimate of cost of capital using book value rather than market value?)
r Yes
r No

* Step 3: Calculate the weighted average cost of capital

Cost of capital = Weight of each component * Cost of the component

= Cost of Equity * Weight of Equity + Cost of Debt * Weight of debt

WHY DOES THE COST OF CAPITAL MATTER?

A. Cashflow to Equity vs. Cashflow to the firm

A firm is composed of both debt and equity investors. Equity investors get cashflows to equity and debt investors get interest and principal payments.
Stakeholder Cashflows to Stakeholder
Equity Investors Net Income
- ( Capital Spending - Depreciation) (1-Debt Ratio)

- D Working Capital (1- Debt Ratio)

= Free Cashflows to Equity

Lenders Interest Expenses (1 - tax rate)

+ Principal Payments

Firm Free Cashflows to Firm

= Equity = Free Cashflows to Equity

+ Lenders + Interest Expenses (1 - tax rate)
+ Principal Payments
First Principle of Discounting: The discount rate chosen for discounting should be appropriate for the cashflows being discounted.

Cashflow Discount Rate PV is Compare to

Cashflows to Equity Cost of Equity Value of Equity Equity Investment

Cashflows to Firm WACC Value of Firm Total Investment =

Debt+Equity

Optimum Capital Structure and Cost of Capital

If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.
* Equivalence of the two approaches

Example: Assume that you have a project that requires a \$100 million investment and produces cashflows to firm of \$20 million through infinity. Assume also that you finance this project with 50% Debt (Interest rate 8%; Perpetual bonds) and 50% equity (Cost of Equity = 15%). The project can be evaluated two ways:

I. Equity Approach:

Cashflows to Equity = Cashflows to Firm - Interest (1 - tax rate ) - Principal repaid

= 20 million - 4 million (1- 0.4) - 0 = 17.6 million

PV of Cashflows to Equity = Cashflows to Equity / Cost of Equity (since it is perpetuity)

= 17.6/0.15 = 117.33

NPV of Project (from Equity standpoint) = PV of Cashflows to Equity - Equity investment

= 117.33 - 50 = 67.33 (since equity is 50% of \$100 million investment)

II. Firm Approach

Cashflows to Firm = 20 million

Market Value of Equity = 117.33 (Note that we use market value instead of book value)

Value of Debt = 50 (Here Market Value = Book Value)

Weighted Average cost of capital = (117.33/167.33) (15%)+(50/167.33) (8% (1 - 0.4)) = 0.1195

PV of Cashflows to Firm = 20 million / 0.1195 = 167.33

NPV of Project (from firm's viewpoint) = 167.33 - Total Investment (100) = 67.33

Illustration: From Cost of Equity to Cost of Capital - Boeing and The Home Depot

• The cost of equity, estimated from the betas, is as follows:

Expected Return for Boeing = 7.50% + 0.94 (5.5%) = 12.67%

For The Home Depot, the estimate of required return is:

Expected Return for The Home Depot = 7.50% + 1.38 (5.5%) = 15.09%

• Boeing has a rating of AA- from Standard and Poorís, leading to a pre-tax cost of debt of 8.25%. This pre-tax cost of debt is based upon the long term government bond rate of 7.50% and a default premium for A+ bonds of 0.75%. The Home Depot is not rated, but its latest borrowings were at a rate of 1% above the government bond rate, leading to a current pre-tax cost of debt of 8.50%. These pre-tax costs of debt are used to estimate after-tax costs of debt, assuming a marginal tax rate of 34%.

After-tax Cost of Debt for Boeing = 8.25% (1-0.34) = 5.45%

After-tax Cost of Debt for The Home Depot = 8.50% (1-0.34) = 5.61%

• Neither company has any preferred stock or convertible debt outstanding, leading to the cost of capital based upon the proportions of debt and equity in each company. The debt and equity proportions are calculated based upon the market values of debt and equity outstanding at the end of 1994 :

 Company Debt Market Value of Equity D/(D+E) Boeing \$2,609 \$18,073 12.61% The Home Depot \$900 \$20,815 4.14%

[Market Value of Equity = Market price per share * Number of Shares]

• The costs of capital are calculated based upon the costs and proportions of each source of financing.

 Company D/(D+E) Cost of Debt E/(D+E) Cost of Equity Cost of Capital Boeing 12.61% 5.45% 87.39% 12.67% 11.76% Home Depot 4.14% 5.61% 95.86% 15.09% 14.70%

• The cost of capital is the appropriate benchmark to use to analyze projects on a pre-debt basis. The return on capital, which is computed based upon the after-tax operating earnings, can be compared to the cost of capital to make a judgment on the performance of these companies. In 1994, for instance, this comparison would have yielded the following results ñ

 Company Return on Capital Cost of Capital Difference Boeing 8.03% 11.76% -3.73% The Home Depot 18.36% 14.70% 3.66%

• Based upon this comparison, we would conclude that, in 1994 at least, Boeingís projects did not measure up to the benchmark, while The Home Depotís projects yielded returns greater than the benchmark. This comparison is equivalent to the comparison made in the earlier section of return on equity to the cost of equity.

Applying The Cost Of Capital Approach

* The textbook example

If an analyst has the costs of equity and debt for different levels of debt, the decision is straightforward: (Assume that the tax rate is 40%)

 D/(D+E) ke kd After-tax Cost of Debt WACC 0 0.105 0.08 0.048 0.105 0.1 0.11 0.085 0.051 0.1041 0.2 0.116 0.09 0.054 0.1036 0.3 0.123 0.09 0.054 0.1023 0.4 0.131 0.095 0.057 0.1014 0.5 0.14 0.105 0.063 0.1015 0.6 0.15 0.12 0.072 0.1032 0.7 0.161 0.135 0.081 0.105 0.8 0.172 0.15 0.09 0.1064 0.9 0.184 0.17 0.102 0.1102 1 0.197 0.19 0.114 0.114

Measures of Short-Term Liquidity Risk

a. Current Ratio

The current ratio is the ratio of current assets (cash, inventory, accounts receivable) to its current liabilities (obligations coming due within the next period).

Current Ratio = Current Assets / Current Liabilities

A current ratio below one, for instance, would indicate that the firm has more obligations coming due in the next year than assets that it can expect to turn to cash. That would be an indication of liquidity risk.

b. Quick Ratio

The quick or acid test ratio is a variant of the current ratio. It distinguishes between current assets that can be converted quickly into cash (cash, marketable securities) from those that cannot (inventory, accounts receivable).
Quick Ratio = (Cash + Marketable Securities) / Current liabilities
The exclusion of accounts receivable and inventory is not a hard and fast rule. If there is evidence that either can be converted into cash quickly, it can be included as part of the quick ratio.

c. Working Capital Turnover Ratios

The management of working capital is often a key component of the management of cash and liquidity risk. One measure of the efficiency of working capital is the magnitude of inventory and accounts receivable, relative to annual cost of goods sold and sales -

Accounts Receivable Turnover = Sales / Average Accounts Receivable

Inventory Turnover = Cost of Goods Sold / Average Inventory

These statistics can be interpreted as measuring the speed with which the firm turns accounts receivable into cash or inventory into sales.

Long-term Solvency and Default risk

Measures of long-term solvency attempt to examine a firm's capacity to meet interest and principal payments in the long term.

Interest Coverage Ratios

The interest coverage ratio measures the capacity of the firm to meet interest payments from pre-debt, pre-tax earnings.

Interest Coverage Ratio = Earnings before interest and taxes / Interest Expenses

The higher the interest coverage ratio, the more secure is the firm's capacity to make interest payments from earnings. Two firms can have the same interest coverage ratio, but can be viewed very differently in terms of risk, because of the volatility in earnings.

The denominator in the interest coverage ratio can be easily extended to cover other fixed obligations such as lease payments.

Fixed Charges Coverage Ratio = Earnings before interest and taxes / Fixed Charges

Finally, this ratio, while stated in terms of earnings, can be restated in terms of cash flows, by using earnings before interest, taxes and depreciation (EBITDA) in the numerator and cash fixed charges in the denominator.

Cash Fixed Charges Coverage Ratio = EBITDA / Cash Fixed Charges

Both interest coverage and fixed charge ratios are open to the criticism that they do not consider capital expenditures, a cash flows that may be discretionary in the very short term, but not in the long term, if the firm wants to maintain growth. One way of capturing the extent of this cash flow, relative to operating cash flows, is to compute a ratio of the two -

Operating Cash flow to CapEx = Cash flows from Operations / Capital Expenditures

While there a number of different definitions of cash flows from operations, the most reasonable way of defining it is to measure the cash flows from continuing operations, before interest but after taxes, and after meeting working capital needs.

Cash flow from operations = EBIT (1-tax rate) - D Working Capital