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Capital Structure and Financial Distress

Wijantini

Prasetiya Mulya Business School

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Prasetiya Mulya Business School

3 Main Causes of Financial Distress

High Leverage /Debt
Poor Management

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Industry Effects

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Prasetiya Mulya Business School

Financing Decision
Debt (Utang) ?

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Equity (Modal Sendiri) ?

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Prasetiya Mulya Business School

Financial Risk

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Additional business risk concentrated on common stockholders when financial leverage is used. (Tambahan risiko jika pinjaman digunakan)

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Prasetiya Mulya Business School

Business Risk
Uncertainty in future Net Profit from Operations* (Ketidakpastian laba operasi di myad) * = EBIT (Earning Before Interest and Taxes) = Laba Usaha
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Prasetiya Mulya Business School

Financial Risk
Consider Two Firms

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Firm U No debt 20 M in assets 40% tax rate

Firm L D =10 M @ 12% 20 M in assets 40% tax rate

Both firms have same EBIT of 3 M. They differ only with respect to use of debt.

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Prasetiya Mulya Business School

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Impact of Leverage (Debt) on Returns Firm U EBIT Interest EBT Taxes (40%) NI ROE
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Firm L 3M 1,20 1,80 0,72 1,08 10.8%

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3M 0 3M 1,2 1,8 M 9.0%

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Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L?

Continued
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Prasetiya Mulya Business School

Financial Risk
Firm U: Unleveraged Bad Economy Avg. Good

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Prob. 0.25 EBIT 2,000 Interest 0 EBT 2,000 Taxes (40%) 800 NI 1,200
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0.50 3,000 0 3,000 1,200 1,800

0.25 4,000 0 4,000 1,600 2,400

Prasetiya Mulya Business School

Financial Risk
Firm L: Leveraged Economy Bad Avg. Prob.* 0.25 0.50 EBIT* 2,000 3,000 Interest 1,200 1,200 EBT 800 1,800 Taxes (40%) 320 720 NI 480 1,080 *Same as for Firm U.
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Good 0.25 4,000 1,200 2,800 1,120 1,680

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Financial Risk
Firm U ROE Firm L ROE Bad 6.0% Bad 4.8% Avg. 9.0% Avg. 10.8% Good 12.0% Good

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16.8%

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Prasetiya Mulya Business School

Business Risk
Uncertainty about future pre-tax operating income (EBIT).
Probability
Low risk High risk

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E(EBIT)

EBIT

Note that business risk focuses on operating income, so it ignores financing effects.
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Prasetiya Mulya Business School

Business Risk
Factors That Influence Business Risk

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Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs.

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Prasetiya Mulya Business School

Business Risk
What is DOL?

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Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firms overall cost structure, the greater the operating leverage.
(More...)

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Prasetiya Mulya Business School

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Probability

Low operating leverage

High operating leverage

EBITL

EBITH

In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.
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Prasetiya Mulya Business School

Capital Structure Theory

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Miller Modigliani - MM theory Corporate taxes

Trade-off theory

Signaling theory

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Prasetiya Mulya Business School

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MM relationship between value and debt when corporate taxes are considered.
Value of Firm, V VL TD VU Debt

0
Under MM with corporate taxes, the firms value increases continuously as more and more debt is used.
Wijantini
Prasetiya Mulya Business School

Trade-off Theory
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.

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Prasetiya Mulya Business School

Signaling Theory

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MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal.

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Prasetiya Mulya Business School

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A second agency problem is the potential for underinvestment. Debt increases risk of financial distress. Therefore, managers may avoid risky projects even if they have positive NPVs.

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Prasetiya Mulya Business School

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Choosing the Optimal Capital Structure: An Example

Currently is all-equity financed.

Expected EBIT = 500,000.

Firm expects zero growth.

100,000 shares outstanding; rs = 12%;

T = 40%; b = 1.0; rRF = 6%; RPM = 6%.
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Prasetiya Mulya Business School

Estimates of Cost of Debt

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Percent financed with debt, wd rd 0% 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% If company recapitalizes, debt would be issued to repurchase stock.
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Prasetiya Mulya Business School

The Cost of Equity at Different Levels of Debt: Hamadas Equation

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MM theory implies that beta changes with leverage.

bU is the beta of a firm when it has no debt (the unlevered beta) bL = bU [1 + (1 - T)(D/S)]

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Prasetiya Mulya Business School

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The Cost of Equity for wd = 20% Use Hamadas equation to find beta: bL = bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%) ] = 1.15 Use CAPM to find the cost of equity: rs = rRF + bL (RPM)

= 6% + 1.15 (6%) = 12.9%

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Prasetiya Mulya Business School

Cost of Equity vs. Leverage

wd 0% 20% 30% 40% 50%
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D/S 0.00 0.25 0.43 0.67 1.00

bL 1.000 1.150 1.257 1.400 1.600

rs 12.00% 12.90% 13.54% 14.40% 15.60%

Prasetiya Mulya Business School

The WACC for wd = 20%

WACC = wd (1-T) rd + we rs

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WACC = 0.2 (1 0.4) (8%) + 0.8 (12.9%) WACC = 11.28%

Repeat this for all capital structures under consideration.

Wijantini
Prasetiya Mulya Business School

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WACC vs. Leverage

wd 0% 20% 30% 40% 50%
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rd 0.0% 8.0% 8.5% 10.0% 12.0%

rs 12.00% 12.90% 13.54% 14.40% 15.60%

WACC 12.00% 11.28% 11.01% 11.04% 11.40%

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What other factors would managers consider when setting the target capital structure?

Debt ratios of other firms in the industry. Pro forma coverage ratios at different capital structures under different economic scenarios. Lender and rating agency attitudes (impact on bond ratings).
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Prasetiya Mulya Business School

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Reserve borrowing capacity. Effects on control. Type of assets: Are they tangible, and hence suitable as collateral?

Tax rates.

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Prasetiya Mulya Business School

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Cost of Capital ( BIAYA MODAL)

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Prasetiya Mulya Business School

COST OF CAPITAL
Cost of capital is the minimum expected rate of return that the market requires in order to attract funds for a particular investment with a given level of risk

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Prasetiya Mulya Business School

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Cost of Capital Components

Debt Preferred Common Equity

WACC (Weighted Cost of Capital)

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Prasetiya Mulya Business School

What capital components should be included?

Evergreen interest-bearing Short-term debt (only in special case)
Long-term debt Common equity

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Prasetiya Mulya Business School

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Should we focus on ex-post (historical) costs or ex-ante (expected) costs? The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on ex-ante costs.

Wijantini

Prasetiya Mulya Business School

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Cost of Debt
Interest is tax deductible, so

kd(1 - T)

= 12%(1 - 0.25) = 9%.

kd= Cost of Debt =suku bunga pinjaman bank

Wijantini

Prasetiya Mulya Business School

Cost of Equity
What are the two ways that companies can raise common equity?

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Companies can issue new shares of common stock. Companies can reinvest earnings.

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Prasetiya Mulya Business School

Cost of Equity
Three ways to determine the cost of equity (ks)

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1. CAPM: ks 2. DCF: ks

= kRF + b(kM - kRF)

= kRF + b(RPM).
= D1/P0 + g.

3. Own-Bond-Yield-Plus-Risk Premium: ks = kd + RP

Wijantini

Prasetiya Mulya Business School

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1. Capital Asset Pricing Model (CAPM)

Whats the cost of equity based on the CAPM?

For example: kRF = 6.0%; RPM = 12% ; b = 1.2

ks = kRF + b(kM - kRF ) = 6.0% + 1.2(12%) = 20.4%

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Prasetiya Mulya Business School

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2. Discounted Cash Flow (DCF)

ke = D1/Po + g
Suppose Charoen Pokphand Indonesia has been earning 20% on equity (ROE = 20%) and retaining 25% (dividend payout ratio or DPO = 75%), and this situation is expected to continue. Whats the expected future g?

Wijantini

Prasetiya Mulya Business School

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Retention growth rate: g = b(ROE) = 0.25(20%) = 5% b = Fraction retained = 1-Payout ratio g = 5% given earlier.

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Prasetiya Mulya Business School

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ks = D1/Po + g

g = 5% given earlier. Do= 100 D1= 100(1+5%)= 105 Po= 650

ks = 105/650 + 5% = 20.18%

Wijantini

Prasetiya Mulya Business School

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3. Bond-Yield-Plus-Risk-Premium
Estimating ks using the own-bond-yield-plus-riskpremium method

ks = kd + RP = 12.0% + 8.0% = 20.0%

This RP CAPM RPM.

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Prasetiya Mulya Business School

Whats a reasonable final estimate of Cost of Equity (rs)?

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Method

Estimate

CAPM
DCF

20.40%
20.18%

kd + RP
Average
Wijantini

20.00%
20.19%
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Whats the WACC?

Weighted Average Cost of Capital (WACC) is the weighted summation of: (i) cost of common equity capital (ks), and (ii) cost of debt capital (kd); WACC represents a firms overall capital cost WACC= wdkd(1 - T) + wsks

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Prasetiya Mulya Business School

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Calculating WACC
Cap.Comp. Weight Debt 60% Common Eq. 40% 100% Comp.Cost Product 9.0%*) 5.4% 20.19% 8.01% WACC= 13.41%

*) After-tax cost of debt = Interest rate Tax savings = kd - kdT = kd (1-T) = 12% (1-25%) = 9%

Wijantini

Prasetiya Mulya Business School

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What factors influence a companys WACC?

Market conditions, especially interest rates and tax rates Uncontrollable The firms capital structure and dividend policy. The firms investment policy. Firms with riskier projects generally have a higher WACC.

Wijantini

Prasetiya Mulya Business School

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4 Mistakes to Avoid
Never base the cost of debt on the coupon rate on a firms existing debt.
Never use the historical average Never use the current Book Value capital structure to estimate the weights Always remember that capital components are funds that come from investors

Wijantini

Prasetiya Mulya Business School