Download Capital Structure and Cost of Capital: Equity vs Debt Financing and more Study notes Corporate Finance in PDF only on Docsity!
Part 9. The Basics of Corporate Finance
The essence of business is to raise money from investors to fund projects that will return more money to the investors. To do this, there are three financial questions the company must answer: how much money should they raise, how best to raise the money and then how to return the profits to the investors. We already know the rule for determining how much money to raise. The company should try to raise enough money to fund every project with positive NPV. This section covers the other two questions.
The financing options available to a company can differ depending on the size of the company. A small business is going to have fewer choices about how to raise funds than General Motors. Although General Motors has its own problems, it can’t raise $100 million from family and friends. In this section we will look at options for large corporations, who are assumed to have good access to financial markets. The next section will look at some of the special problems that face small businesses and start-up companies.
Large corporations: What are their financing options and what do they cost?
There are two basic ways for a company to raise capital: equity and debt. Equity investors get ownership in the company but do not have a guaranteed return. Issuing stock is the most obvious way to raise funds using equity. Retained earnings (when the company uses its own earning to finance projects) are also an equity investment. With retained earnings, the company takes money that could have been returned to shareholders and uses it to fund capital projects. Effectively, it is using the shareholders money to fund these projects, increasing the value of their equity holdings. Because of this, we should think of both retained earnings and newly-issued shares as examples of equity financing.
Debt financing is borrowing; investors get a promise of fixed future payments, but do not have any ownership. Borrowing can be done through a financial intermediary, such as a bank, or directly by issuing bonds.
There is a third category of assets, sometimes called hybrid securities, that is between equity and debt. Examples include warrants, convertible bonds and preferred stock. They all have some features that seem like equity and other features that seem like debt. Firms are finding it increasingly attractive to use these hybrid instruments; however, they are an advanced topic and we will not discuss them here.
What are the costs of the options?
The mix of debt and equity that a company uses is called its capital structure. For example, if a corporation has assets of $100,000 that were financed as follows,
Debt 80, Equity 20,
Total Capital 100,
we would say that its capital structure consists of 80% debt and 20% equity.
Later on, we will look at how managers decide on the capital structure that is best for their company; for the moment, we will take it as given. The capital structure that a firm wants to have is called their target structure. Ideally, firms would like to keep their capital structure close to their target structure when they raise funds. One way to do this would be to raise funds from each source according to their target weight, so if our hypothetical company needed to raise $ million it could raise $8 million from debt and $2 million from equity. However, there can be fixed costs associated with each type of capital used and so, in practice, companies will often raise funds from only one source at a time, but will tend to mix types of funding over time to keep close to the desired capital structure on average.
Each source of capital has its own cost. The cost of debt is basically the interest rate that the company has to pay on that debt. In order to issue equity, investors must expect to get a sufficient return on their investment, given the risk of the company. The required return on the investment is the cost of equity.
The cost of capital for a company that uses several different sources of capital is the average of the individual costs. Since there may be different amounts of each type of capital, we calculate it as a weighted average, with the weights being the share of that type of capital in the targeted capital structure.
The Weighted Average Cost of Capital Formula
To determine the weighted average cost of capital you follow 4 steps:
- Determine the target amount of each type of capital
- Determine the weights
- Determine the cost of each type of capital
- Calculate the weighted average
For the moment, we do not know how to do steps 1 and 3; however, given that information, we can do steps 2 and 4. The table below gives the amount of each type of capital for the company (Step 1). We can then determine the shares or weights of each type of capital (Step 2). The third column gives us the information about costs (Step 3). We then calculate the weighted average cost by multiplying the cost of each kind of capital by its weight and then adding the costs together.
Value (given) Weight Cost (given) (^) Weight×Cost Debt 80,000 0.8 8% 6.4% Equity 20,000 0.2 12% 2.4% Total Capital 100,000 1 8.8%
The weighted average cost of capital for this company is 8.8%.
So far, we have assumed that the cost of capital isn’t affected by the amount of capital the firm is trying to raise. Sometimes this may not be true. If a firm was issuing a lot of debt, it might increase the probability that the firm could not repay all the debt. This would increase the risk of the firm’s debt, and so increase the cost. In these situations, we would want to look at the
Example: A firm’s bonds currently sell at a yield to maturity of 8%. The relevant corporate tax rate for this company is 35%. The cost of debt is 0.08*(1-0.35) = 0.052 or 5.2%.
The Cost of Equity
To determine the cost of equity we need to ask ‘what rate of return will investors require to invest in our company?’ One way to do this is to recognize that investors need to earn the base interest rate plus some extra amount for the risk of the investment. Since equity investments imply more risk than debt investments, we know that equity investors need a greater return than bond investors. This gives us a formula:
Cost of Equity = Bond Yield + Additional Risk Premium
Notice that you use the bond yield, not the bond yield adjusted for the tax shield (new tax laws have changed how dividends are treated at the individual level, but we will ignore the effect of individual taxes for a moment)
How do you measure the risk premium? The firm needs to look at financial markets and see what return investors expect when they make investments of equal risk. Similarly, we could look at the relationship between expected returns and risk in equity markets and use this to calculate the necessary expected return for stock in our company. We will leave this task for a future course.
Cost of Retained Earnings
Retained earnings are the cash that company has. While this seems like “free” financing because it doesn’t have to be raised in the market, it does have an opportunity cost. If the firm did not use this money for financing it could return it to the shareholders. In other words, using retained earnings is a form of equity finance because it takes money from shareholders. Since it equity finance, it should be priced at the cost of equity.
Firms seem to have a preference for retained earnings to fund investments, for a variety of reasons. Retained earnings are actually a little bit cheaper than new equity financing since the firm does not have to pay the cost of issuing shares. In addition, outside investors may not have good information about the prospects of the firm, which would make them hesitant to invest in newly-issued equity
The downside of using retained earnings is that it allows the firm to invest shareholder’s money without having to convince investors that it is a good idea. If the returns to the project do not exceed the cost of capital, it will be hard to sell shares or bonds to skeptical investors. However, if firms can use cash they have on hand, they escape the discipline imposed by the market.
The Cost of Hybrid Securities
We can use the same techniques for any security. To determine the current capital structure, look at the market value of the outstanding securities. To determine the cost of a particular type of capital, ask ’What return does this security have to offer in order to get investors to hold it?’
Detailed Example of Calculating the Cost of Capital
The Pacific Company has raised funds from both equity and debt. Initially, it issued 1m shares at $11/share. It also issued 5,000 bonds 10-year bonds at a 7% coupon rate (paid semi-annually) with a face value of $1,000. At a 7% market rate, the price of the bonds was $1,000.
Total equity financing is $11 million, while total debt financing is $5 million, for $16 million of total capital. Since the book entry was made at the initial market values they are the same. Capital structure is 69% equity and 31% debt.
Five years later, both the prices of the shares of stock and interest rates have changed so the market structure may differ from the book structure. We look at the market and find that shares are currently selling for $13, which means that the market value of equity is $13 million. Bonds are now selling at 7.6%, so that the price is $975 and total debt is $4.9 million. The capital of the firm at market prices is $17.9 million; 73% from equity and 27% from debt.
The company’s long-run financial plan is to target a capital structure of 70% equity and 30% debt. The current structure is close enough to the target structure that it doesn’t need to make adjustments to its financing.
We will calculate the cost of capital assuming the 70/30 mix. To find the cost of capital we need to know the interest rate on our bonds, the corporate tax rate, and the risk premium for our stock. From the market, we see that our bonds are offering a yield of 7.6%. We will assume that the corporate tax rate is 30% and that our stock has an expected yield of the “bond rate” + 5%.
We add together the debt and equity components of our WACC:
Debt Component = (debt cost)(debt share) = 7.6%(1-.3)(.3) = 1. Equity Component = (equity cost)(equity share) =(7.6%+5%)(.7) = 8.82,
giving us a cost of capital of 10.42.
When evaluating the project the company would use a cost of capital of 10.42 to see if the NPV of the project is positive. When they actually fund the project, it is unlikely that they will raise money with 70% equity and 30% debt. They might use retained earnings first (the next section will explain why) and then shift to debt to make up the remainder. The expectation would be that other projects might be financed differently (maybe all from issued equity) but that on average they would get the 70/30 split. If not, the company may then want to restructure its financing.
Capital Structure and Leverage: Determining the Best Capital Structure
Up to this point, we have been treating a firm’s capital structure as fixed. However, a firm can choose different capital structures. Should a firm use more equity or more debt? We’ll take up that question now.
Let’s start with a hypothetical investment decision. Say that you can buy an apartment building for $800,000. You expect that earnings from the apartment building will be $80,000 per year after expenses. It also turns out that we happen to have $800,000 that we can use to buy the apartment building (lucky us). However, we could also borrow the money from the bank at 6% interest. Should we use our own money, or borrow the money from the bank?
While the ‘½ debt’ strategy reduces net earnings because of the interest cost, it increases the average return on equity since it only uses half as much equity as the ‘no debt’ strategy. The problem is that changes in earnings now have a bigger effect: When things go well, ROE is higher, but when things go poorly, ROE is lower. This shows up as the higher standard deviation of ROE under the ‘½ debt’ strategy.
Modigliani-Miller
Using leverage allows the firm to have a higher ROE, but only at the cost of more risk. Is the higher return worth the extra risk? In other words, how does the mix of equity and debt affect the owners? Surprisingly, at some level it shouldn’t matter. This was the insight of Franco Modigliani and Merton Miller in a famous argument that became known as the MM proposition. What matters for a business is the cash flow it can generate. Capital structure is just about how the cash flow is divided up: The owners of the debt get the interest payments, while the owners of the equity get whatever is left over. The value of the firm is given by the total amount of the cash generated by the firms. MM argues that, under certain conditions, how the cash flow is divided up doesn’t change the total amount of cash, and so it doesn’t matter what the mix of the debt and equity is.
We know from our discussion of leverage that an increase in debt increases the risk and expected return of the equity. We will skip the details of the proof of the MM proposition, but basically it shows that as the use of debt increases, equity investments in the firm become riskier, and the cost of equity financing increases, but the share of equity financing falls just enough so that the average cost of capital is unchanged. Since the cost of capital is unchanged, there is no effect on the firm.
While MM says that it doesn’t matter whether a firm uses equity or debt, the proposition also depends on some strict assumptions. If the assumptions do not hold, the amount of debt a firm has can affect the cost of capital.
The tax benefits of debt
The point of MM is that it doesn’t matter how the cash flow is divided as long as the division doesn’t change the total amount of cash. However, if we introduce taxes, how the cash is split up may affect the total amount. In the US, tax distortions show up in two different areas. On the corporate side, interest is deductible from earnings when calculating corporate income taxes. Debt shields income from taxes, reducing the amount that goes to the government, and increasing the amount left over for investors. On the household side, dividends and certain capital gains are currently taxed at a different rate than ordinary income (although the law on this changes from time to time) which makes this kind of income more attractive.
To see the effect of a tax distortion, we can compare earnings under three different schemes: All equity, ½ debt when debt is not tax deductible, and ½ debt when it is deductible. For this example, initial capital is $1,000,000, the interest rate is 10%, the corporate tax rate is 35%, all individual income is taxed at the same rate, and earnings are generated each year.
All Equity ½ debt, ½ equity not deductible
½ debt, ½ equity deductible Operating Income 200,000 200,000 200, Interest Deduction - - -50, Tax 70,000 70,000 52, Interest Cost - 50,000 50, Equity Income 130,000 80,000 97, Total Income 130,000 130,000 147,
Total income is the amount paid to debt and equity investors. Shifting towards debt (the second column) does not change the total amount of income, it just means that debt holders get a larger share. However, when debt is deductible, it shields some income from taxation and so increases the total amount of income.
The value of the extra debt is given by (corporate tax rate)×(interest rate)×(debt) which in this case equals $17,500, the increase in total income.
Lowering the tax rate on dividends works in the other direction, making debt less attractive. On net, given the current tax rates, the tax advantages of debt outweigh the tax disadvantages, although the difference is not large. However, even with this tax advantage, firms might not want to use all the debt they can. One concern is that debt obligates a firm to make regular interest payments. If a company uses a lot of debt, a temporary shortfall in earnings could lead to the company not being able to make its interest payments, forcing the company to take drastic action or go bankrupt.
Bankruptcy costs associated with debt
The reason that companies raise funds is usually to buy assets, such as buildings or machinery, in order to produce and sell goods. Often these assets are very illiquid and cannot be easily sold, or can only be sold at a reduction in value. For example, Burger World could sell its restaurants to Pizza Delight, but the value of the restaurants to Burger World is more than the price Pizza Delight would be willing to pay. The restaurants reflect an investment by Burger World in kitchen appliances better suited for burgers than pizza, and all the structures are designed with the corporate style in mind. The assets are specific to Burger World and have less value with other companies. This is true for lots of corporate assets, and not just the tangible ones. Employees will have spent time learning the hamburger industry and how things are done at Burger World, and some of these skills will not be useful or valued elsewhere. The employees also have information and relationships with customers and suppliers that might not be easily rebuilt if lost.
The existence of these specific assets means that if the company goes bankrupt it will lose value. Having debt increases the risk of a company going bankrupt as it forces the company to make regular payments or default on the debt.
To show how this works, let’s walk through a simple numerical example. A company has $ billion of assets specific to that company and generates earnings of $100 million per year. The assets were financed with $1,500 million debt at 10% per year and $500 million of equity. To
The problem is that issuing new equity signals to the market that the company believes its stock is overpriced (whether it actually is or not). Giving this signal is bad for the company and might lead it to not offer new equity. One way around this is to use retained earnings as a source of equity rather than newly issued stock. Retained earnings do not have this signaling problem (you do not gain anything from the stock being overpriced) and have the additional benefit of no floatation costs.
Tradeoff Theory of Capital Structure
The MM proposition is a good place to start thinking about corporate finance since it isolates the specific costs of debt and equity that affect the financing decision. However, we need to move beyond MM to incorporate these costs into the firm’s decision.
The “tradeoff” theory of capital structure says that companies are not indifferent between using debt and equity, rather there are costs and benefits of using debt. Debt provides the benefit of a tax shield but also has bankruptcy costs. Bankruptcy costs are small for small amounts of debt, but get larger as the amount of debt increases.
A firm should decide on its use of debt by comparing the costs and benefits. The higher the level of corporate taxes, the greater the value of the tax shield, so the more debt you should use. For low levels of debt, the probability of bankruptcy is also low, so debt has little bankruptcy costs. In other words, at low levels of debt, debt is relatively cheaper than equity (adjusting for risk) and so should be used. At higher levels of debt, there is an increased risk of bankruptcy, and so the cost of debt increases. At some point, the increased possible bankruptcy costs outweigh the benefit of the additional tax shield and so the firm should not use additional debt.
Companies with greater expected bankruptcy costs should use less debt. The greater bankruptcy cost could be due to more uncertainty about earnings, which increases the probability of bankruptcy. Or it could be that the company’s assets have little salvage value and therefore would be worth less if the company goes bankrupt.
Capital Structure Folk Wisdom
We can summarize long-term financing policy by a few guidelines that describe how firms behave. First, a little debt is a good thing (because of the tax shield) but you do not want too much (the risk of bankruptcy). The bankruptcy cost, and so the use of debt, should depend on how risky earnings are: Companies with stable earnings should use more debt, while companies with uncertain earnings should use more equity. Companies with a high cost of financial distress, particularly with assets specific to the firm, should avoid debt.
Firms often follow a “hierarchy” of financing: First, they look to retained earnings for financing. Retained earnings offer the benefit of no floatation costs and avoid the signaling problems of equity issuance. After retained earnings are exhausted, firms shift to debt financing. Once they reach their desired limit on debt, they shift to equity issuance.
Returning Money to Shareholders
If a firm is successful it will find itself with a positive net cash flow; it’s making a profit! What should the firm do with the cash? One option is to use the cash to finance additional projects for the firm. As long as the NPV of the project is positive, and the firm wants to use equity financing, this is the best use for the cash. Investing in positive NPV projects will increase the value of the company and increase shareholder wealth by increasing the price of their shares. On the other hand, if the NPV for all new projects at the firm are negative, the firm should return the cash to the owners.
Shouldn’t this decision depend on how valuable the cash is to the shareholders? Yes, but the NPV calculation already includes that, since the cost of capital includes the cost of equity - the opportunity cost to shareholders of providing funds to the firm. In any case, if you as a shareholder happen to have an opportunity to invest in a project with a greater NPV, you can always sell your shares (which have gone up in price) and get the cash that way.
The firm has two ways of returning cash to shareholders: it can pay dividends or buy back shares in the company.
How Dividends Work
Generally companies pay dividends quarterly. The process starts with the dividend being authorized by the board of directors. The date they do this is called the declaration date. A list is kept of the owner of each share, called the owner of record. The date of record is when it is determined who the owners are, and so who should be paid. Because it takes some time for a share purchase to be recorded, only those who have purchased the stock two days before the date of record are eligible for the dividend. This is called the ex-dividend date. The payment date is when the payments are formally made (the check is mailed).
In many firms, shareholders have an option of either receiving dividends or accepting an equivalent value in new shares. This is called a dividend reinvestment plan. This makes it easy for shareholders who would prefer the additional shares over the cash to follow this policy. The shares are either purchased in the market, or the firm can issue new shares, which provides another source of financing to the firm. From the IRS’s point of view, a stock reinvestment plan is just the same as the firm paying a cash dividend and then the investor using the money to purchase shares, and so it is considered taxable income.
Buying Back Shares
Another way to increase shareholders’ wealth is by reducing the number of shares. Since we can think of the value of each share as the present value of the cash flow divided by the number of shares, reducing the number of shares makes each share more valuable. Instead of paying dividends, firms could use their excess cash to buy back shares. This would increase the value of shares, and investors could get the cash by then selling their shares.
An advantage of buying back shares is that long-term capital gains may be taxed at a lower rate than dividends. Investors would get more money after taxes if the company repurchased its shares than if they paid dividends (as long as the investors held the shares for a long-enough time)
Stock Splits
On the surface, stock splits look like another way for shareholders to gain. In a stock split, firms multiply the number of shares held by each investor. For example, a firm could exchange 2 new
