Recitation VI Jiro E. Kondo Summer 2003Today’s Recitation: Capital Structure. I. MM Thm: Capital Structure Irrelevance. II. Taxes and Other Deviations from MM. 1I. MM Theorem. • A company is considering undertaking a project which requires $10 million in initial funding (e.g. the project will incur $10 million in costs before it becomes profitable). �→ Of course, the $10 million question is: should you undertake the project? �→ But we’re not there yet. In principle, under-taking a project involves other decisions that could be important. �→ So here’s a $1 million question: if you go forth with this project, how should you finance it? �→ Well, there are lots of financing options: common stock, preferred stock, debt (tons of debt options), bank loans, internal cash, etc. Is one financing mix better than the others? • The mix of securities that are issued to fi- nance a firm’s projects is its capital structure. 2I. Continued... • Is financing really a million dollar question? �→ Easiest to think of this in a frictionless mar- ket (FM) context... • What’s a FM? It’s a market with the fol -lowing features... -Notaxes. - No transactions costs. - Investors and firms have access to the same financing technologies at the same cost. - Symmetric information. - Operating and financing decisions are inde -pendent. • Wow! Lots of assumptions and all of them are unrealistic. Why do we care about this context? �→ Because it gives a simple answer to the fi- nancing question and will give us framework to think of more realistic refinements later. 3I. Continued... • MM Theorem: If markets are frictionless, the firm’s financing mixture of debt and equity does NOT affect its value (i.e. capital struc -ture is irrelevant). �→ Suggests that the financing decision is ac -tually a $0 question. �→ The only reason the financing question would be important would be if it affected firm value. MM says it doesn’t. • Intuition: Investors shouldn’t be willing to pay a premium for a more or less levered ver -sion of a firm because they can accomplish this leverage or undo it themselves under the same terms as the firm (by borrowing on their own account). Why pay a premium for something you can do yourself for free? 4I. Continued... • However, someone might respond: ”But how can firm value not change? The cost of equity is higher than the cost of debt, so levered firms should have a cost of capital that is closer to the cost of debt (i.e. a lower cost of capital) and, as a result, should be more valuable.” �→ What’s wrong with this argument? 5I. Continued... • Remember: Leverage changes the firm’s cost of equity (and maybe even the cost of debt). Only frictions can make capital struc-ture affect the value of the firm. �→ Why? As debt becomes a larger fraction of firm value, equity, which still picks up most of the cashflows risk, does so with a smaller value. The total premium on this risk is the same as with an unlevered firm, but now this premium is apportioned over a smaller amount of equity value. Hence, the premium per unit of equity value (i.e. cost of equity) goes up. In other words, the cost of equity increases with higher leverage. �→ Likewise, as a company increases its lever-age, its debt can eventually become risky (i.e. default risk can increase). �→ MM says that these costs increase just enough to keep the firm’s cost of capital constant across all possible leverage ratios. 6I. Continued... • Intuition: Think of a CAPM-style argument: All assets and portfolios are priced using a com-mon framework (the security market line). Since the firm’s operating decisions are independent of its financing decisions, the underlying cash-flow risks of the firm do not depend on its capital structure. This means that, irrespec-tive of the capital structure decision, the firm should have the same value. 7II. Taxes and Other Deviations From MM. • Corporate Taxes: Recall that interest pay -ments on debt are tax deductible while pay -ments to investors via dividends are not. �→ There is a debt tax-shield, but no corre -sponding dividend (or equity) tax-shield. • What happens when we take this asymmetric tax treatment into account? �→ Can think of this in the MM framework with a simple refinement. �→ Who has a claim on the pre-tax cashflows of the firm? �→ If the firm issues both debt and equity, clearly the debtholders and equityholders have some sort of claim on these pre-tax CFs. �→ The government also has a claim. In fact, if accounting profits are high, it’s claim can be quite large. 15II. Continued... • With corporate taxes, think of the MM the -orem holding, but that the value of the firm is shared between debtholders, equityholders, AND the government. �→ In this case, what is the goal of capital structure? �→ Minimize the value of the governments stake. �→ Likewise, maximize the value of debt tax- shields. • Howdowecalculate thePVofthese tax- shields? 16II. Continued... • Big Picture: Considering only the corpo-rate tax rate seems to suggest that issuing as much debt as possible is optimal. This maxi-mizes the value of all tax-shields and minimizes the government’s share of firm value. �→ This is just as simple an answer as MM. Does it miss something too? • Other issues... � Personal Taxes: There’s also a difference in tax treatment between income earned on debt through interest payments (taxed as income) and income earned on equity through stock price appreciation (taxed as capital gains). �→ These can negate all the tax advantage of debt. You can even find a tax advantage of equity in some cases. 20II. Continued... �→ Since different people don’t necessarily fall in thesameincometax bracket, they mayhave different relative preferences for debt and eq-uity. �→ Some firms can