Escolar Documentos
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Paul Laux
September 2010
Learning Goals
Whats the point? What should you know? What should you be able to do?
Contents
1 Theme 2
2 Introduction 2
1
3 A straw man 11
8 Conclusion 26
2
1 Theme
"Would you like that pizza cut into six pieces or eight, sir?"
"EightIm really hungry."
Yogi Berra.
2 Introduction
Capital structure
Mini-outline Points
Capital structure
3
Capital structure
Specific industries
Specific countries
Categories of countries
Capital structure
We begin by thinking about when there would not be a role for policy
Differences between the no role world & the one we live in help us know
4
Example: Industry variation (1)
Note overall average debt ratio; note nature of some outlier industries
Note overall average debt ratio; note nature of some outlier industries
5
An example
Mini-outline Points
Overall, both banking & legal system setups are conducive to more equity in
Germany
An example
6
An example
German firms as compared to U.S. firms tend use much less debt. Why
might that be?
7
Some reasons relate to the way German banks are involved in the econ-
omy (such as owning equity and underwriting stock issues). Bank debt bring
very effective monitoring of management into the picture (bankers watch well),
and thus helps to militate some of the manager-owner agency problems that
come with extensive equity financing. This results in equity finance being more
workable, and so German firms use relatively more of it.
There is another reason for the German-U.S. capital structure contrast. U.S.
bankruptcy laws seem to be strongly oriented toward maintaining the firm as a
going concern. The U.S. law has an entire set of procedures that are oriented to-
ward reorganization rather than liquidation. Under the reorganization proce-
dures of the US bankruptcy code, a firms management and shareholders seem
to have the bargaining advantage. For example, the firm (not the creditors)
proposes a reorganization plan, and may take six months to do so. The cred-
itors can essentially do nothing until this plan is filed. As a result of this and
many other advantages, violations of absolute priority are commonplace in
the U.S. In Germany, the bankruptcy laws are more creditor-friendly. The firm
has only a short time to file a reorganization plan, and creditors are not stayed
by it. It is likely that part of the reason that German firms shy away from debt is
that this creditor-friendly environment increases the costs of financial distress
for firms with heavy debt.
A brief mention, in case you do not know: Absolute priority is the legal
ordering of claims on the firms assets. Secured creditors are supposed to stand
first in line to be paid, then unsecured creditors, the preferred shareholders,
and then, after everyone else has been paid, common stockholders get the
residual. Violations of absolute priority mean that common stockholders do
better than the rules say they should.
8
Modigliani and Miller Theorems
Ask when capital structure would be irrelevant for value & cost of
capital
Those conditions must be violated if capital structure is very rele-
vant
The rest of this note is devoted to describing the conclusions of some of the
first giants in this area, and to showing the circumstances in which there are
NO costs to getting the capital structure choice wrong. No costs to getting
it wrong means no reduction in the value of the firm and no increase in
the overall cost of capital. These ideas are often summarized in the statement
that capital structure is irrelevant under the conditions to be described. The
point of examining the circumstances in which capital structure is irrelevant is
to focus our thinking on the issues that DO make capital structure relevant by
eliminating the issues that do not.
Mini-outline Points
9
What the giants changed
Before
After
10
What the giants changed
Much after
Nobel Prizes
Modigliani: also for other work in life cycle consumption & savings, and
economic growth
Miller: mainly for this work, though shared with others who worked on
portfolio formation, risk, & expected return
In the sections that follow, I discuss the ideas that brought finance into
the modern age: The Modigliani-Miller Propositions. The seminal papers are
Modigliani and Miller (1958) and Modigliani and Miller (1963). Prior to the
work of M&M, the relationship between capital structure and the cost of capi-
tal was considered to be complex and mysterious. Executives had a vague idea
that there was some "optimal" mix of debt and equity that would minimize
their companys cost of capital. But they had only the roughest of ideas of how
to determine it.
M&M and those that extended their reasoning came along and reasoned,
very simply and very convincingly, that executives ought to look to market
imperfections as the source of an optimal capital structure. Market imper-
fections are real-world features like taxes; bankruptcy costs; conflicts between
owners and managers, or between shareholders and bondholders, due to dif-
fering goals. Why? Because, they showed us, without any market imperfec-
tions capital structure affects neither the value of the firm, nor the value of its
common stock, nor the weighted average cost of capital.
For these insights, Modigliani and Miller won separate Nobel Prizes. In
awarding Nobel Prizes for this revolutionary work in finance, the Committee
cited the wide-spread effect that M&M have had, not just on the academic sci-
ence of finance, but especially on the everyday practice of business finance.
11
3 A straw man
Setting for a claim that we can refute, and learn in the process
For the straw man case, assume there were no taxes or other market im-
perfections. Nothing gets in the way of market prices reflecting value directly
and completely.
The reason for abstracting from market imperfections is to lay out, as cleanly
as possible, a framework for reasoning. We will add back some imperfections
later, starting with taxes.
What does the straw man look like? Consider a company that has no debt
in its capital structure. Ill call the company Straw Man Incorporated (I am very
imaginative!).
12
Portrait of the Straw Man
Facts
It happens that cash flows and earnings are the same thing for this firm, for
its book depreciation is exactly equal to the new investment needed to keep the
firm operating in its current fashion.
Presidents proposal
Straw Man setup Straw Man leverage chart (choose sheet manually if necessary)
1
Borrow 3 of the firms asset value
1
Use proceeds to repurchase 3 of the market value of shares
Under the proposal
13
calculate ROA, ROE, and EPS for a normal year
Also for 1- outlier year (upside & downside)
Plot EPS as a function of OCF
Even better, the president believes that her plan will increase the stock price
and the current value of the firm. She believes that the firms expected earnings
per share will be higher under her plan, and that investors will therefore assess
a greater present value of future earnings than before.
Presidents proposal
Straw Man setup Straw Man with M&M (choose sheet manually if necessary)
On this first examination, it looks like the president has a point. The capital
market likes earnings (because they are the same as cash flows for this firm).
By financing 13 of the firm with debt, at a cost of debt that is less than the return
on assets, she can lever the earnings to increase the expected ROE. By also
repurchasing some shares, she can increase the expected EPS, too Good deal,
right?
Thats the straw man. Lets see if we can burn it. To do so, we will leave
Straw Man Incorporated for a few minutes and visit with Modigliani and Miller.
Then we will return to consider Straw Man.
14
4 Capital structure irrelevance in an idealized world
Mini-outline Points
1. To maximize E, maximize V
2. What is firm-value-maximizing choice?
3. If leverage changed firm value, what would investors do?
15
M&Ms argument: Intuition
To maximize E, maximize V
Why?
coupon
D= r f , a number known to all and
If borrowing increased firm value, investors would refuse to buy the shares
16
M&Ms argument: Intuition
If borrowing decreased firm value, investors would refuse to sell the shares
The pay-alike portfolios that are the risk-equivalent alternative for their in-
vestment funds would be an unattractive alternative
No sellersbuyers would bid up price
You can sell firms shares, buy risk-alike firms shares for e1, and borrow to du-
plicate the debt position yourself
Statement of M&M 1
VL = VU and EL = EU
17
What is the stock-debt financing mix that will maximize the value of the
firm? M&M Proposition I says there isnt any particular one. The financing
mix doesnt matter.
What will you do? Sell your stock in the levered firm. By doing this, you
can raise enough money to by the stock of the unlevered firm and have e1 left
over. Put the e1 in your pocket. Go to your bank or broker and borrow exactly
the same amount on the same terms as the levered company did. Between the
shares of the unlevered company and your borrowing, you have put together
a portfolio that has exactly the same cash flow characteristics as the levered
company you sold. So you are even on that score. Why did you do this? Put
you hand in your pocket and feel the e1. Thats why.
If the levered firm still sells for e1 more than the unlevered firm, even af-
ter your selling pressure on the price, then the new owner will replicate your
scheme. And so will the owner after her. And so on. Eventually, all this selling
will drive the price down. The selling will continue until the two companies,
the levered and the unlevered one, sell for the same price. In the end, the lev-
ering of the firm cannot affect its value. This is M&M Proposition I.
We could motivate the M&M arbitrage argument a little more formally. This
is what they did back in the 1950s.
18
M&Ms portfolios (1)
Two investment strategies with the same payoffs at every time must have the same
upfront investment. Otherwise, arbitrage is attractive
Two investment strategies with the same payoffs at every time must have the same
upfront investment. Otherwise, arbitrage is attractive
! VU = EL + DL
! VU = EL + DL ! VU = VL
! EU = EL
M&M 1
VL = VU and EL = EU
What if Strategy B (the levered equity) did somehow become higher valued?
Mini-outline Points
19
M&Ms arbitrage play
What if Strategy B (the levered equity) did somehow become higher valued?
Homemade leverage
What if Strategy B (the levered equity) did somehow become higher valued?
Big picture
Using cash that unlevered firm is not paying in interest to pay interest on your
debt
Result: M&M 1
VL = VU and EL = EU
20
4.2 M&M I: Practical Implications
Focus us on what CAN matter for value. What can make M&Ms arguments fail?
Examples
Focus us on what CAN matter for value. What can make M&Ms arguments fail?
Do borrowing that their investors wish they could do, and payout
the cash
Pay more attention to capital structure when they have more monopoly
position
Look for investors who like a particular payout pattern
21
the leverage. The ability to do so implies that the firms leverage is redundant
and cannot add value.
Note the importance of the assumption that firms and investors can borrow
and lend on the same terms. If investors cannot borrow and lend on the same
terms as firms, then the arbitrage proofs will not go through. At first glance, it
is fairly realistic to suppose that investors terms will not be worse than firms.
After all, investors will be borrowing against stock as collateral. Stock is easily
liquidated, unlike the fixed assets that firms use as collateral. Further, stock
can be kept under the watchful eye of the lender (i.e., be held by the broker),
unlike the firms assets which are under the control of the management. In fact
margin loans (loans from brokers to investors to purchase extra shares of stock)
generally carry low rates of interest.
So what might cause M&M I to be violated? Well, lots of things. The real
value of the theorem is to focus us on what those things might be. Were not
quite ready to do that in force at this stage of the discussion, but I can give the
flavor with an example.
In the US, the 1986 Tax Reform Act imposed a constraint on personal lever-
age. Investors can deduct the interest expense on debt incurred to support
investments, but only to the extent that such interest expense does not exceed
investment income by more than a per year limit. If a firm has a lot of share-
holders who are apt to be affected by this constraint, they may represent a
clientele who could benefit from the firm taking on debt. This would require,
of course, that they want debtas they would if they desire to hold a higher
risk-higher return asset than the firms unlevered equity.
The general idea behind the CFOs effort is to add value by satisfying some
clientele whose demands have not been addressed by existing securities, or to
satisfy those demands in a cheaper way than is currently possible. This has
been the goal of a great deal of recent financial innovation, or the creation of
new types of securities (especially derivative securities).
22
Value and the WACC
Leverage does not change firm value or equity value, per M&MI
Rearranging:
re,L
VL D EL + D D
= EL re,U EL r f = EL re,U EL r f
D
= re,U + EL (re,U rf )
Final expression is M&M II
Cost of levered equity
23
M&M II, graphically
How does this square with the CAPMs guidance on the cost of capital (i.e.,
required expected returns for the risk? Very nicely.
assets = e,U
24
So assets = equity&debt
E E
Thus assets = D + E e,L + D+E D
D
! e,L = assets + A ( assets D )
In our riskfree debt case, D = 0
First, notice that the firms overall risk level, call it assets , must be unaf-
fected by the capital structure choice because the firms overall cost of capital
is unaffectedand is therefor the same as the for the equity of the unlevered
firm. This should be intuitive: the firm has not changed the composition of
its assets, and the unlevered firm has a balance sheet where assets (with their
characteristic level of risk) are supported by a single equity claim, which must
therefore have the same risk. Second, remember that, as a matter of statis-
tics,the of a portfolio is just the weighted average of the s of its components
(covariance risk averages!). Assuming the levered firm is financed only with
debt and equity, then the right side of the firms balance sheet is a portfolio
of these two components, with the same average the other side of the firms
balance sheet.
Using this reasoning, the risk of the levered firms equity can be isolated.
It is equal to the asset plus an add-on risk that depends on the firms debt
ratio.
The reason that the cost of equity increases with debt is that its increases
with debt. The increase in the cost of equity, based on its increases risk, is
just enough to offset the cost savings from emphasizing cheaper debt in the
firms capital structure, leaving the overall WACC for the levered firm just the
same as for the unlevered firm. Thus, the M&M theorems are irrelevance
theorems.
25
If stock price does rise, do A below & opposite of B. Make money?
Buy whats cheap, sell whats dear
Note that B undoes Ls leverage
If stock price falls, do B below & opposite of A. Make money?
Price pressures
What should B cost? Why?
Straw Burning! (choose sheet manually if necessary)
The details of the arithmetic are laid out in the Excel workbook that accom-
panies this note, available on our Teaching Materials Grid web page.
26
7 The case of risky debt
D
What happens to the cost of debt? How does it vary with A?
Lets acknowledge that the there is some probability that the firm will not
be able to pay its debt obligations. And that the chance of default increases
with the amount the firm borrows. This does not change M&M Proposition
I (the one about the total value of the firm) and changes M&M Proposition II
(the one about WACC and described above with a picture) only a little bit. The
modified picture looks like this.
Note that the central part of Proposition II has not changed: the firms
WACC is still invariant to its capital structure. What has changed is that the
cost of debt rises when the firm borrows beyond a certain point. That point
is where the possibility of de-fault becomes more than negligible. However, at
the same point, the cost of equity ceases to rise so fast with debt. In one sense,
this is simply a mechanical result: if the WACC is to stay constant as debt is
added even though the cost of debt is rising, then the cost of equity must rise
less steeply. Proposition II is simply a consequence of Proposition I.
The economic reason that the cost of equity rises less steeply with risky debt
is that the debtholders are then sharing in some of the firms risk. If the firm
does badly, then they might not have their claim paid in full. Since the value of
the firm is invariant to the capital structure, then what is bad for debtholders
must be good for shareholders.
8 Conclusion
Two misconceptions
Can you explain why these are incorrect?
Since r D is generally less than re , a CFO can increase firm value by levering-
up with debt?
Since the firm must make periodic payments to debtholders, but is not
required by law to pay dividends, levering-up reduces firm value.
27
References
Modigliani, F. and M. Miller, 1958, The Cost of Capital, Corporate Finance and
the Theory of Corporation Finance, American Economic Review 48, 261-297.
Modigliani, F. and M. Miller, 1963, Corporate Income Taxes and Cost of Capital:
A Correction, American Economic Review 48, 433-443.
28