Capital Structure I Finance Theory II (15.402) – Spring 2003 – Dirk Jenter 2 • • • • • • • • Financing Review Case: Intel Corporation Finance Theory II (15.402) – Spring 2003 – Dirk Jenter The Big Picture: Part I - Financing A. Identifying Funding Needs Feb 6 Case: Wilson Lumber 1 Feb 11 Case: Wilson Lumber 2 B. Optimal Capital Structure: The Basics Feb 13 Lecture: Capital Structure 1 Feb 20 Lecture: Capital Structure 2 Feb 25 Case: UST Inc. Feb 27 Case: Massey Ferguson C. Optimal Capital Structure: Information and Agency Mar 4 Lecture: Capital Structure 3 Mar 6 Case: MCI Communications •Mar 11•Mar 1313 • Valuation: • Financing: Finance Theory II (15.402) – Spring 2003 – Dirk Jenter The Key Questions of Corporate Finance How do we distinguish between good investment projects and bad ones? How should we finance the investment projects we choose to undertake? 4 • • • → → → • → → → Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Financing Policy Real investment policies imply funding needs. We have tools to forecast the funding needs to follow a given real investment policy (from Wilson Lumber) But what is the best source of funds? Internal funds (i.e., cash)? Debt (i.e., borrowing)? Equity (i.e., issuing stock)? Moreover, different kinds of ... internal funds (e.g., cash reserves vs. cutting dividends) debt (e.g., Banks vs. Bonds) equity (e.g., VC vs. IPO) 25 Capital Structure • • →→→ Maturity →→→• value Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Capital Structure represents the mix of claims against a firm’s assets and free cash flow Some characteristics of financial claims Payoff structure (e.g. fixed promised payment) Priority (debt paid before equity) Restrictive Covenants Voting rights Options (convertible securities, call provisions, etc) We focus on leverage (debt vs. equity) and how it can affect firm 6 Choosing an Optimal Capital Structure • • sheet, i.e.,• Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Is there an “optimal” capital structure, i.e., an optimal mix between debt and equity? More generally, can you add value on the RHS of the balance by following a good financial policy? If yes, does the optimal financial policy depend on the firm’s operations (Real Investment policy), and how? 37 Sources of Funds: US Corporations 1979-97 0 20 40 60 80 100 120 79 80 81 82 84 85 86 87 89 91 92 93 94 96 97 g Eq y Finance Theory II (15.402) – Spring 2003 – Dirk Jenter -40 -20 83 88 90 95 % of total financinInternal Debt uitCompanies and Industries Vary in Their Capital Structures Industry Debt Ratio* (%) Electric and Gas 43.2 Food Production 22.9 Paper and Plastic 30.4 Equipment 19.1 Retailers 21.7 Chemicals 17.3 Computer Software 3.5 Average over all industries 21.5% * Debt Ratio = Ratio of book value of debt to the sum of the book value of debt plus the market value of equity.8 Finance Theory II (15.402) – Spring 2003 – Dirk Jenter 49 Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Returns Average Risk Premium Portfolio Nominal Real Treasury bills 3.8 0.7 0.0 Government bonds 5.6 2.6 1.8 Corporate bonds 6.1 3.0 2.3 Common stocks (S&P 500) 13.0 9.7 9.2 Small-firm common stocks 17.7 14.2 13.9 Source: Ibbotson Associates, Inc., 1998 Yearbook (Brealey & Myers p.155) (over T-Bills) Average Annual Rate Average rates of return on Treasury bills, government bonds, corporate bonds, and common stocks, 1926-1997 (figures in percent per year) 10 Plan of Attack → → Taxes → → → → Finance Theory II (15.402) – Spring 2003 – Dirk Jenter 1. Modigliani-Miller Theorem: Capital Structure is irrelevant 2. What’s missing from the M-M view? Costs of financial distress Other factors 3. “Textbook” view of optimal capital structure: The choice between debt and equity 4. Apply/confront this framework to several business cases Evaluate when its usefulness and its limitations 511 M-M’s “Irrelevance” Theorem • • Proof: • • price. • Q.E.D. Finance Theory II (15.402) – Spring 2003 – Dirk Jenter MM Theorem (without taxes for now). Financing decisions are irrelevant for firm value. In particular, the choice of capital structure is irrelevant. From Finance Theory I, Purely financial transactions do not change the total cash flows and are therefore zero NPV investments. With no arbitrage opportunities, they cannot change the total Thus, they neither increase nor decrease firm value. 12 Example • • → • → → → • Firm A Firm B In state 1: 160 160 In state 2: 40 40 Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Consider two firms with identical assets (in $M): Firm A is all equity financed: Firm A’s value is V(A) = E(A) Firm B is financed with a mix of debt and equity: Debt with one year maturity and face value $60M Market values of debt D(B) and equity E(B) Firm B’s value is (by definition) V(B) = D(B) + E(B) MM says: V(A) = V(B) Asset (economic, not book) value next year: 613 Proof 1 • • • → The payoff to Firm A’s equity → • Q.E.D. Claim’s value Debt 100 40 40 0 Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Firm A’s equity gets all cash flows Firm B’s cash flows are split between its debt and equity with debt being senior to equity. In all (i.e., both) states of the world, the following are equal: The sum of payoffs to Firm B’s debt and equity By value additivity, D(B) + E(B) = E(A) next year: Firm A’s Equity Firm B’s Firm B’s Equity In state 1: 160 60 In state 2: 14 M-M Intuition 1 • • • • of how the pie is divided up. Finance Theory II (15.402) – Spring 2003 – Dirk Jenter If Firm A were to adopt Firm B’s capital structure, its total value would not be affected (and vice versa). This is because ultimately, its value is that of the cash flows generated by its operating assets (e.g., plant and inventories). The firm’s financial policy divides up this cashflow “pie” among different claimants (e.g., debtholders and equityholders). But the size (i.e., value) of the pie is independent 715 V E D E D V Finance Theory II (15.402) – Spring 2003 – Dirk Jenter “Pie” Theory I 16 Proof 2 • • → → E(B) = $50M • • • Finance Theory II (15.402) – Spring 2003 – Dirk Jenter In case you forgot where value additivity comes from… Assume for