Step 4. Raising the Additional Funds Needed
5. Estimating Shareholder Wealth and Stock Price
Strasburg should now recapitalize,meaning that it should issue debt and use the pro- ceeds to repurchase stock. The shareholder’s wealth after the recap,as it is commonly called, would be equal to the payment they receive from the share repurchase plus the remaining value of their equity. To find the remaining value of equity, we need to specify how much debt is issued in the new capital structure. Since we know the percent of debt in the capital structure and the resulting value of the firm, we can find the dollar value of debt as follows:
.
For example, at the optimal capital structure of 40 percent debt, the dollar value of debt is about $88,889 ⫽0.40($222,222).
The market value of the remaining equity, S, is equal to the total value minus the value of the debt. At the optimal capital structure, the market value of equity is
$133,333 ⫽$222,222 ⫺$88,889. Column 4 in Table 13-4 shows the market value of equity under the various capital structures. Notice that the value of equity declines as the percent financed with debt increases. At first glance, it looks like increasing lever- age hurts shareholders. But keep in mind that the shareholders also receive cash equal to the amount of new debt when the company repurchases the stock:
. Cash raised by issuing debt⫽D⫺D0
D⫽wdV
FIGURE 13-4 Strasburg’s Required Rate of Return on Equity at Different Debt Levels
10 20 60
14 12
8 6 4
0 Required Return on Equity
(%) 18
2 10 16
30 40 50
rs
rRF= rRF
Percent Financed with Debt (%)
Risk-Free Rate:
Time Value of Money Plus Expected Inflation Premium for Financial Risk
Premium for Business Risk
Estimating the Optimal Capital Structure 499
Here D0is the amount of debt the company had before the recap, which for Strasburg was zero.
For example, at the optimal capital structure, Strasburg will issue $88,889 in debt and use the proceeds to repurchase stock.Thus, the total wealth of the sharehold- ers after the repurchase will be the cash they receive in the repurchase ($88,889) plus the value of their remaining equity ($133,333), for a total wealth of $222,222.No- tice that their total wealth increases from its original level of $200,000 to the new level of $222,222, a gain of $22,222.This is exactly equal to the increase in total value experienced by Strasburg, so the shareholders reap the full rewards of the re- capitalization.
Prior to the announced recap, Strasburg had a $200,000 market value of equity and 10,000 shares of stock outstanding (n0). Therefore, its stock price prior to the re- cap was $20 per share ($200,000/10,000 ⫽$20).
To find the price per share after the recap, consider the sequence of events. (1) The company announces the recap and issues new debt. (2) The company uses the proceeds from the debt issue to repurchase shares of stock. These events don’t occur exactly simultaneously, so let’s examine each event separately.
Strasburg Issues New Debt Strasburg announces its plans to recapitalize, and borrows $88,889. It has not yet repurchased the stock, and so the $88,889 of debt pro- ceeds are temporarily used to purchase short-term investments such as T-bills or other marketable securities. Using the corporate valuation model from Chapter 12, the total corporate value is now equal to the value of operations, calculated by dis- counting the expected free cash flows by the new WACC, plus the value of any non- operating assets such as short-term investments. Therefore, Strasburg’s total value after issuing debt but before repurchasing stock is
⫽$222,222 ⫹$88,889 ⫽$311,111.
Total corporate value⫽Value of operations⫹Value of short-term investments TABLE 13-4 Strasburg’s Stock Price and Earnings per Share
Percent Market Market Number of
Financed Value of Value Value Shares after Earnings
with Debt, Firm, of Debt, of Equity, Stock Price, Repurchase, Net Income, per Share,
wd V (D) S P n NI EPS
(1) (2)a (3)b (4)c (5)d (6)e (7)f (8)g
0% $200,000 $0 $200,000 $20.00 $10,000 $24,000 $2.40
10 206,186 20,619 185,567 20.62 9,000 23,010 2.56
20 212,540 42,508 170,032 21.25 8,000 21,934 2.74
30 217,984 65,395 152,589 21.80 7,000 20,665 2.95
40 222,222 88,889 133,333 22.22 6,000 19,200 3.20
50 216,216 108,108 108,108 21.62 5,000 16,865 3.37
60 200,000 120,000 80,000 20.00 4,000 13,920 3.48
Notes:
aThe value of the firm is taken from Table 13-3.
bThe value of debt is found by multiplying the percent of the firm financed with debt in Column 1 by the value of the firm in Column 2.
cThe value of equity is found by subtracting the value of debt in Column 3 from the total value of the firm in Column 2.
dThe number of outstanding shares prior to the recap is n0⫽10,000. The stock price is P ⫽[S ⫹(D ⫺D0)]/n0⫽[S ⫹D]/10,000.
eThe number of shares after the recapitalizations is n ⫽S/P.
fNet income is NI ⫽(EBIT ⫺rdD) (I ⫺T), where EBIT ⫽$40,000 (taken from Table 13-1), rdcomes from Table 13-2, and T ⫽40%.
gEPS ⫽NI/n.
Recall from Chapter 12 that the value of equity is the total corporate value minus the value of all debt. Therefore, the value of equity after the debt issue but prior to the repurchase, Sp, is
⫽Total corporate value ⫺Value of all debt
⫽$311,111 ⫺$88,889 ⫽$222,222.
Although the corporate valuation model will always provide the correct value, there is a quicker and more intuitive way to determine Sp in a recapitalization. Sp reflects the wealth of the shareholders under the new capital structure, and, as we noted earlier, this is equal to the value of their equity after completion of the recapi- talization plus the cash they receive in the repurchase:
⫽ $133,333 ⫹($88,889 ⫺$0) ⫽$222,222.
This is exactly the same value as calculated above, but it can be computed with fewer steps and is perhaps a little more intuitive.
The price per share after issuing debt but prior to repurchasing stock, Pp, is
Strasburg Repurchases Stock What happens to the stock price during the repur- chase? The short answer is “nothing.” It is true that the additional debt will change the WACC and the stock price prior to the repurchase, but the subsequent repurchase itself will not affect the stock price.19To see why this is true, suppose the stock price was lower right before the repurchase than after the repurchase.If this were true, it would be possi- ble for an investor to buy the stock the day before the repurchase and then reap a reward the very next day.Current stockholders would realize this and would refuse to sell the stock unless they were paid the price that is expected immediately after the repurchase.
Therefore, the post-repurchase price, P, is equal to the stock price after the debt is- sue but prior to the repurchase. Using the relationships in the previous section, we can write this as:20
(13-9) Column 5 in Table 13-4 shows the price per share for the various capital struc- tures. Notice that it, too, is maximized at the same capital structure that minimizes the WACC and maximizes the value of the firm.
⫽[S⫹(D⫺D0)]/n0. P ⫽Sp/n0
⫽$222,222/10,000⫽$22.22.
⫽Sp/n0
⫽Value of equity after debt issue but prior to repurchase Number of shares outstanding prior to repurchase Pp⫽Price per share after debt issue but prior to repurchase
Sp⫽S⫹(D⫺D0)
Sp⫽Value of equity after the debt issue but prior to the repurchase
19As we discuss in Chapter 14, a stock repurchase may be a signal of a company’s future prospects, or it may be the way a company “announces” a change in capital structure, and either of those situations could have an impact on estimated free cash flows or WACC. However, neither situation applies to Strasburg.
20There are other ways to get to Equation 13-9. By definition, P ⫽S/n. Since P is also the stock price im- mediately prior to the repurchase and all debt proceeds are used to repurchase stock, the dollar value of repurchased shares is P(n0⫺n) ⫽D ⫺D0. We have two equations (one defining the price per share after the repurchase) and one defining the dollar value of repurchased stock. We have two unknowns, n and P.
We can solve for the repurchase price: P ⫽(S ⫹D ⫺D0)/n0.
Estimating the Optimal Capital Structure 501
Strasburg used the entire debt proceeds to repurchase stock, which means the number of repurchased shares is equal to the debt, D, divided by the repurchase price, P. Given 10,000 shares outstanding prior to the repurchase, the number of remaining shares after the repurchase, n, is
At the optimal capital structure, Strasburg will repurchase $88.889/$22.22 ⫽ 4,000 shares of stock, leaving 6,000 shares outstanding (see Column 6 of Table 13-4).
The expected EBIT is $40,000, from Table 13-1. Using the appropriate interest rate, amount of debt, and tax rate we can calculate the net income (Column 7 in Table 13-4) and the earnings per share (Column 8).
Analyzing the Results
We summarize the results graphically in Figure 13-5. Notice that the cost of equity and the cost of debt both increase as debt increases. The WACC initially falls, but the rapidly increasing costs of equity and debt cause WACC to increase when the debt ratio goes above 40 percent. As indicated earlier, the minimum WACC and maximum corporate value occur at the same capital structure.
Now look closely at the curve for the value of the firm, and notice how flat it is around the optimal level of debt. Thus, it doesn’t make a great deal of difference whether Strasburg’s capital structure has 30 percent debt or 50 percent. Also, notice that the maximum value is about 11 percent greater than the value with no debt. Al- though this example is for a single company, the results are typical: The optimal capi- tal structure can add 10 to 20 percent more value relative to zero debt, and there is a fairly wide region (from about 20 percent debt to 55 percent) over which value changes very little.
In the last chapter we looked at value-based management and saw how companies can increase their value by improving their operations. There is good news and bad news regarding this. The good news is that small improvements in operations can lead to huge increases in value. But the bad news is that it’s often very hard to improve operations, especially if the company is already well managed.
If instead you seek to increase a firm’s value by changing its capital structure, we again have good news and bad news. The good news is that changing capital structure is very easy—just call an investment banker and issue debt (or the reverse if the firm has too much debt). The bad news is that this will add only a relatively small amount of value. Of course, any additional value is better than none, so it’s hard to understand why there are some mature firms with zero debt.
Finally, Figure 13-5 shows that Strasburg’s EPS steadily increases with leverage, while its stock price reaches a maximum and then begins to decline. For some compa- nies there is a capital structure that maximizes EPS, but this is generally not at the same capital structure that maximizes stock price. This is one additional reason we focus on cash flows and value rather than earnings.
What happens to the costs of debt and equity when the leverage increases?
Explain.
Using the Hamada equation, show the effect of financial leverage on beta.
Using a graph and illustrative data, identify the premiums for financial risk and business risk at different debt levels. Do these premiums vary depending on the debt level? Explain.
Is expected EPS maximized at the optimal capital structure?
⫽n0⫺(D/P).
n ⫽Number of outstanding shares remaining after the repurchase
FIGURE 13-5 Effects of Capital Structure on Value, Cost of Capital, Stock Price, and EPS
Stock Price ($)
EPS ($) Price
EPS
10
0 20 30 40 50 60
Percent Financed with Debt 0
15 4
6
2
0 20
5 10 25
Cost of Capital (%)
Cost of Equity
After-Tax Cost of Debt WACC
10 20 30 40 50 60
0
Percent Financed with Debt 5
0 15
10 20
Value of Firm ($)
10
0 20 30 40 50 60
Percent Financed with Debt 50,000
0 100,000 150,000 200,000 250,000
Checklist for Capital Structure Decisions
Firms generally consider the following factors when making capital structure decisions:
1. Sales stability.A firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company with unstable sales. Utility companies, because of their stable demand, have historically been able to use more financial leverage than industrial firms.
2. Asset structure.Firms whose assets are suitable as security for loans tend to use debt rather heavily. General-purpose assets that can be used by many businesses make good collateral, whereas special-purpose assets do not. Thus, real estate companies are usually highly leveraged, whereas companies involved in techno- logical research are not.
3. Operating leverage.Other things the same, a firm with less operating leverage is better able to employ financial leverage because it will have less business risk.
4. Growth rate.Other things the same, faster-growing firms must rely more heavily on external capital (see Chapter 11). Further, the flotation costs involved in sell- ing common stock exceed those incurred when selling debt, which encourages rapidly growing firms to rely more heavily on debt. At the same time, however, these firms often face greater uncertainty, which tends to reduce their willingness to use debt.
5. Profitability.One often observes that firms with very high rates of return on in- vestment use relatively little debt. Although there is no theoretical justification for this fact, one practical explanation is that very profitable firms such as Intel, Microsoft, and Coca-Cola simply do not need to do much debt financing. Their high rates of return enable them to do most of their financing with internally generated funds.
6. Taxes. Interest is a deductible expense, and deductions are most valuable to firms with high tax rates. Therefore, the higher a firm’s tax rate, the greater the advantage of debt.
7. Control.The effect of debt versus stock on a management’s control position can influence capital structure. If management currently has voting control (over 50 percent of the stock) but is not in a position to buy any more stock, it may choose debt for new financings. On the other hand, management may decide to use equity if the firm’s financial situation is so weak that the use of debt might sub- ject it to serious risk of default, because if the firm goes into default, the managers will almost surely lose their jobs. However, if too little debt is used, management runs the risk of a takeover. Thus, control considerations could lead to the use of eitherdebt or equity, because the type of capital that best protects management will vary from situation to situation. In any event, if management is at all insecure, it will consider the control situation.
8. Management attitudes.Because no one can prove that one capital structure will lead to higher stock prices than another, management can exercise its own judg- ment about the proper capital structure. Some managements tend to be more con- servative than others, and thus use less debt than the average firm in their industry, whereas aggressive managements use more debt in the quest for higher profits.
9. Lender and rating agency attitudes.Regardless of managers’ own analyses of the proper leverage factors for their firms, lenders’ and rating agencies’ attitudes fre- quently influence financial structure decisions.In the majority of cases, the corpo- ration discusses its capital structure with lenders and rating agencies and gives much weight to their advice.For example, one large utility was recently told by Moody’s Checklist for Capital Structure Decisions 503
and Standard & Poor’s that its bonds would be downgraded if it issued more debt.
This influenced its decision to finance its expansion with common equity.
10. Market conditions. Conditions in the stock and bond markets undergo both long- and short-run changes that can have an important bearing on a firm’s opti- mal capital structure. For example, during a recent credit crunch, the junk bond market dried up, and there was simply no market at a “reasonable” interest rate for any new long-term bonds rated below triple B. Therefore, low-rated compa- nies in need of capital were forced to go to the stock market or to the short-term debt market, regardless of their target capital structures. When conditions eased, however, these companies sold bonds to get their capital structures back on target.
11. The firm’s internal condition.A firm’s own internal condition can also have a bearing on its target capital structure. For example, suppose a firm has just suc- cessfully completed an R&D program, and it forecasts higher earnings in the immediate future. However, the new earnings are not yet anticipated by investors, hence are not reflected in the stock price. This company would not want to issue stock—it would prefer to finance with debt until the higher earnings materialize and are reflected in the stock price. Then it could sell an issue of common stock, retire the debt, and return to its target capital structure. This point was discussed earlier in connection with asymmetric information and signaling.
12. Financial flexibility.Firms with profitable investment opportunities need to be able to fund them.An astute corporate treasurer made this statement to the authors:
Our company can earn a lot more money from good capital budgeting and operating decisions than from good financing decisions. Indeed, we are not sure exactly how financing decisions affect our stock price, but we know for sure that having to turn down a promising venture because funds are not available will reduce our long-run profitability. For this reason, my primary goal as treasurer is to always be in a position to raise the capital needed to support operations.
We also know that when times are good, we can raise capital with either stocks or bonds, but when times are bad, suppliers of capital are much more willing to make funds available if we give them a secured position, and this means debt. Further, when we sell a new issue of stock, this sends a negative “signal” to investors, so stock sales by a mature company such as ours are not desirable.
Putting all these thoughts together gives rise to the goal of maintaining financial flexibility,which, from an operational viewpoint, means maintaining adequate reserve borrowing capacity.Determining an “adequate” reserve borrowing capacity is judgmen- tal, but it clearly depends on the factors discussed in the chapter, including the firm’s forecasted need for funds, predicted capital market conditions, management’s confidence in its forecasts, and the consequences of a capital shortage.
How does sales stability affect the target capital structure?
How do the types of assets used affect a firm’s capital structure?
How do taxes affect the target capital structure?
How do lender and rating agency attitudes affect capital structure?
How does the firm’s internal condition affect its actual capital structure?
What is “financial flexibility,” and is it increased or decreased by a high debt ratio?
Summary
This chapter examined the effects of financial leverage on stock prices, earnings per share, and the cost of capital. The key concepts covered are listed below:
䊉 A firm’soptimal capital structureis that mix of debt and equity that maximizes the stock price.At any point in time, management has a specifictarget capital structure in mind, presumably the optimal one, although this target may change over time.
䊉 Several factors influence a firm’s capital structure. These include its (1) business risk,(2) tax position,(3) need for financial flexibility,(4) managerial conser- vatism or aggressiveness,and (5) growth opportunities.
䊉 Business riskis the riskiness inherent in the firm’s operations if it uses no debt. A firm will have little business risk if the demand for its products is stable, if the prices of its inputs and products remain relatively constant, if it can adjust its prices freely if costs increase, and if a high percentage of its costs are variable and hence will decrease if sales decrease. Other things the same, the lower a firm’s business risk, the higher its optimal debt ratio.
䊉 Financial leverage is the extent to which fixed-income securities (debt and pre- ferred stock) are used in a firm’s capital structure. Financial riskis the added risk borne by stockholders as a result of financial leverage.
䊉 Operating leverage is the extent to which fixed costs are used in a firm’s opera- tions. In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small change in sales results in a large change in ROIC.
䊉 Robert Hamada used the underlying assumptions of the CAPM, along with the Modigliani and Miller model, to develop the Hamada equation, which shows the effect of financial leverage on beta as follows:
b ⫽bU[1 ⫹ (1 ⫺T)(D/S)].
Firms can take their current beta, tax rate, and debt/equity ratio to arrive at their unlevered beta,bU, as follows:
bU⫽b/[1 ⫹(1 ⫺T)(D/S)].
䊉 Modigliani and Millerand their followers developed atrade-off theory of capi- tal structure.They showed that debt is useful because interest istax deductible, but also that debt brings with it costs associated with actual or potential bankruptcy.
The optimal capital structure strikes a balance between the tax benefits of debt and the costs associated with bankruptcy.
䊉 An alternative (or, really, complementary) theory of capital structure relates to the signalsgiven to investors by a firm’s decision to use debt versus stock to raise new capital. A stock issue sets off a negative signal, while using debt is a positive, or at least a neutral, signal. As a result, companies try to avoid having to issue stock by maintaining a reserve borrowing capacity, and this means using less debt in
“normal” times than the MM trade-off theory would suggest.
䊉 A firm’s owners may decide to use a relatively large amount of debt to constrain the managers.A high debt ratio raises the threat of bankruptcy,which carries a cost but which also forces managers to be more careful and less wasteful with share- holders’ money.Many of the corporate takeovers and leveraged buyouts in recent years were designed to improve efficiency by reducing the cash flow available to managers.
Although each firm has a theoretically optimal capital structure, as a practical matter we cannot estimate it with precision. Accordingly, financial executives gener- ally treat the optimal capital structure as a range—for example, 40 to 50 percent debt—rather than as a precise point, such as 45 percent. The concepts discussed in this chapter help managers understand the factors they should consider when they set the target capital structure ranges for their firms.
Summary 505