UNSW Business School

FINS3625 Applied Corporate Finance

Capital Structure
Observations from Week 2 exercise

• Some suggested excluding Cyberoptics. Why?

• Use the most recent data (2016) vs. average of three years
• Book or Market value equity
Key steps and why (in estimating Cost of Capital)

• Observed betas in the market may be “levered” as those companies may have
debt
• Hence, de-lever the observed betas using Hamada equation for each observed
betas
• Average the unlevered betas in the industry which represents the business risk of
the industry.
• To estimate the subject company’s beta, re-lever the unlevered industry beta
(Business risk) with the subject company’s debt level (Financial risk)
Combining Week 1 & 2

Starting with the end in mind

Our ultimate purpose is to determine ”Value” (Week 4) & evaluate opportunities
(Week 5)

• Week 1 – Use historical financials to generate pro forma financials based on the
identified efficiencies, synergies.

• Week 2 – Estimate the appropriate cost of capital of the business (Business &
Financial Risks)

• This week – what is the Capital Structure, given various situation?

• This requires you to use your Week 1’s work to “model” and Week 2’s work
to understand it is about “business & financial risk”
Focus of Capital Structure

Debt vs. Equity

• Benefits and problems using debt

• How much should we use? - Financial Policy

• Impact on value and business

Fully equity funded startup biz

• Start-up funding of $1,000 of equity capital

• $500 for the distiller
• $300 for raw material
• $200 for wages, utilities, etc.
• Since Assets = Liabilities + Equities
• Assets = $1,000
• Equities = $1,000
• Liabilities = $0 as it is 100% equity funded (no debt)
• Say it generates $143 EBIT and $100 Net Income
• 10% Return on Equity (100/1000)
Income

No Debt
Base Case 20% Increase

EBIT 143 172

Interest - -
Earnings before tax 143 172
Tax 43 51
Net income 100 120

Percentage change in net income 20%

Net Income of $100 is to equity holder

Consider Business Risk

• $143 EBIT and $100 Net Income are expected results

• What if EBIT increase by 20% and decrease by 50%

Income (if EBIT increases by 20%)

No Debt
Base Case 20% Increase

EBIT 143 172

Interest - -
Earnings before tax 143 172
Tax 43 51
Net income 100 120

Percentage change in net income 20%

Income (if EBIT increases by 20%)

No Debt
Base Case 20% Increase

EBIT 143 172

Interest - -
Earnings before tax 143 172
Tax 43 51
Net income 100 120

Percentage change in net income 20%

Net Income increases by $20 (or 20%) is to equity holder

Risks - What if EBIT drops by 50%?

No Debt
Base Case 20% Increase

EBIT 143 172

Interest - -
Earnings before tax 143 172
Tax 43 51
Net income 100 120

Percentage change in net income 20%

Risks - What if EBIT drops by 50%?

Base Case 50% Decrease 50% Decrease 50% Decrease

with 20% Debt with 50% Debt
EBIT 143 72 72 72
Interest - - 10 25 @5% Interest
Earnings before tax 143 72 62 47
Tax 43 21 18 14
Net income 100 50 43 33

Percentage change in net income -50% -57% -67%

Net Income drops proportionally by 50% (equity holder)

Consider Business Risk

• $143 EBIT and $100 Net Income are expected results

• What if EBIT increase by 20% and decrease by 50%

• Returns to equity holder proportionally go up and down

• What if there is debt? 20% debt funded?

• Consider financial risk!

What if it was 20% Debt funded? $200 debt

Base Case 50% Decrease 50% Decrease 50% Decrease

with 20% Debt with 50% Debt
EBIT 143 72 72 72
Interest - - 10 25 Rate
@5% Interest @5% Interest
Earnings before tax 143 72 62 47
Tax 43 21 18 14
Net income 100 50 43 33

Percentage change in net income -50% -57% -67%

What if it was 50% Debt funded?

Base Case 50% Decrease 50% Decrease 50% Decrease

with 20% Debt with 50% Debt
EBIT 143 72 72 72
Interest - - 10 25 @5% Interest
Earnings before tax 143 72 62 47
Tax 43 21 18 14
Net income 100 50 43 33

Percentage change in net income -50% -57% -67%

The use of debt financing magnifies changes in cash flow to equity

Value of this biz

If the cash flow changes as the leverage changes, how do we

determine Debt vs. Equity funding?

First, we need to understand

the consequences of Capital Structure decision

Consider 50/50 biz which is 50/50 funded by debt & equity

50/50 Biz
$2000 start-up funding:
• $1000 debt from Uncle (10% interest 5 years term)
• $1000 equity from Aunt

1st year - $500 net profit

• $200 salary the sole employee
• $100 interest payment to Uncle as promised
• $200 dividends to Aunt

2nd year - $0 net profit

• Can’t pay interests to the debt from Uncle
• Event of default – Uncle took control of 50/50 biz
50/50 Biz

Lessons learned about the use of debt

Lesson 1
Aunt (Equity provider) learns Capital Structure:
“Control rights of equity holders depends on the satisfaction of the debt holders’
term.”

Lesson 2
In the event of default,
the business can continue to operate under the control of a different owner (ie,
the debtholder became new equity holder).
50/50 Biz

An over-aggressive capital structure could jeopardise

equity holder’s control of the business

But, does debt provider want to take control of the business?

NO! Hence, there are debt covenants to prevent defaults

?Burton Sensors Case?
Burton’s situation

P.3 Burton Sensors, Inc Case Study - Covenants

An over-aggressive capital structure could jeopardise

equity holder’s control of the business

Need to analyse financials to ascertain situation

Week 3 Exercise
 How about value?

Does capital structure impact on value?

Value Implications of Capital Structure Decision

Law of Conservation of Value

And

Law of Conservation of Risks

“in a perfect market”

Law of Conservation of Value

Pizza and Pie Scenario

Pizza 1: $20 Pizza 2: $?? Pizza 3: $??

4 slices to different people 8 slices to different people
Since the size & quality of the pizzas are the same, they should have the same
price no matter how many slices
Like businesses, size and quality of the profits matters, not how profits are sliced
 The law of conservation value states that in a perfect market, capital structure policy has no effect on firm
value. Whether a business is funded with no debt or loads of debt, its value is exactly the same. The law of
M&MI
conservation of value states that business value is conserved (i.e., there is no dissipation of value) regardless of
how claims on the business are structured.

This is often referred to as the pizza principle. To illustrate, suppose that Lorenzo the pizza chef offered
Modigliani & Miller
two pizzas for sale. The pies were identical except that one pie was cut into 8 slices and the other into 16 slices.
Based on the notion that the 16-slice pizza offered more slices, Lorenzo priced it at double the price of the 8-
M&M
slice I – In
pie. Would youaever
“Perfect
buy the more Market” withpie?
expensive 16-slice noWhattax, nowere
if you transaction
really hungry andfee, noof distress,
16 slices no
pizza sounded better? asymmetric information,
Of course you would not. You appreciate that when pricing pizza, it is the size and quality of the pizza that
matters, notLeverage
how the pizza isand
sliced.Capital Structure
This same principle holds fordoes not
businesses. matter
When pricing a to the itfirm
business, is the value
size and quality of the profits that matter, not how the profits are sliced.
(shareholder’s wealth) A business can have lots of debt, or
little debt, but in perfect markets the underlying business value remains the same. It is the size and growth
trajectory of the profits that create business value, not how those profits are divided. The structure of the claims
on theValue
business is thedoesn’t
profits market matter avalue
lick if theof
sizethe
of thetotal cash
total profits flow
is the same.from the asset (ie, pizza)

Figure 1. Firm value across levels of financial leverage.

Source:
M.J. Schill Management of Financial
Policy Decisions: Capital Structure Policy
Source: Created by author.
Law of Conservation of risks

Brussels sprouts and dessert

Jack & Jill - Eat your brussels sprouts, you can have your ice cream

Option 1 – Jack & Jill eat one each and get an ice cream each (fair!)

Option 2 – Jill eats both

What many ice cream should Jill gets?

Law of Conservation of risks

Brussels sprouts and dessert

Jack & Jill - Eat your brussels sprouts, you can have your ice cream
No matter who eats the brussels sprouts or have more people to share the brussels sprouts,
the # of brussels sprouts and ice cream remains the same
In business, risks & risk premium

Investors only accept the risk with a promise of rewarding risk premium
M & M II
Modigliani & Miller II
In perfect world
Page 5 UV7078
Capital Structure policy has no effect on firm risk. As risk is
where D/V is the proportion of debt in the capital structure, kD is the required return on debt, and kE is the
conserved, WACC must remain constant
required return on equity. Because of the law of conservation of risk, the prediction in Figure 2 must be the
4

case. The weighted average cost of capital must remain constant across levels of financial leverage since the
The cost
total of equity
risk remains constant. increases as the firms leverage increases

Figure 2. Firm cost of capital across levels of financial leverage.

Source: Created by author.

If you are interested in the details…

Modigliani & Miller

The American Economic Review, Jun 1958

The Cost of Capital, Corporation Finance and the Theory of Investment

In real life, we operate in an “imperfect” market

We have:
Tax
Tax has benefits – tax shield
Transaction cost
Financial distress
Information Asymmetry

Therefore, Capital Structure matters

In real life, we operate in an “imperfect” market

But, where does the value come from?

and
to whom does it go to?
 Capital Structure & Value

Remember: Assets = Liabilities + Equity

Thus, value of Assets = value of liabilities + value of equity

Refer to Capital Structure Exercise Spreadsheet

Key assumptions – EBIT unchanged, the Use of Debt is used to pay equity
Complete tabs: Assets; Debt + Equity; Effects

The exercise demonstrated:

Value of Assets = Value of Debt + Value of Equity = Value of Unlevered Firm + Value of Tax Benefits
Capital Structure
EXHIBIT & Value
7 Value of the Firm with Tax Shields

P
or
Capital Structure & Value

The Value to SH sheet shows:

Whilst the market value of the equity declines with increase in

leverage, shareholders are better off on a “per-share” basis
Practical recapitalisation deal

A hostile takeover situation:

• A corporate raider wanted to acquire Company A

• Initial offer at $45/share then kept raising the offer to $61 per share

• The board of Company A rejected the offer saying that it was inadequate and argue that a
recapitalisation plan can achieve the same value. (Borrow and pay dividends or buyback)

• Company A increased to maximum borrowing of $1,738,095,000 at pre-tax cost of debt

10.5% in perpetuity
• Currently, it has $172,409,000 borrowing on balance sheet

• Additional debt proceed would be paid to shareholders as special dividend

A few reasonable questions:

• Why can’t shareholders lever on their own to create the same effects (M&M I)?

• Imperfect market – different borrowing costs, different tax rate, different borrowing
capacity, etc

• If it is good to leverage, why not leverage even higher?

• Debt capacity and financial distress (eg. 50/50 Biz)

In practice,
• Debt holder will also price in Agency and Transaction cost.

• Cost of Financial Distress, but hard to estimate. Debt to a certain point will break the
company

• Debt overhang – cap the firm’s ability to raise new equity as the debt increases the risk or
turn down value-creating project as the firm gets too concerned managing debt (Burton?)

• Downgrade in credit rating which increase margins on borrowing

• 100% debt funded is equivalent to debt holder taking over equity holder

• Debt risk becomes equity risk and therefore will require a return like equity

• Not desirable as there are differences between Debt and Equity holders
Debt vs. Equity providers
• Remember, there are differences between debt holders and equity holders:

Debt holders Equity Holders

Owner of a financial asset Owner of a business
Term specific Perpetual
Regular income Discretionary dividends
No up or downside Full up and downside
Right to call default Could lose control
Senior (1st one out) Junior (whatever is leftover)

• Debt holders don’t want to be Equity holders

• Equity holders don’t want to lose control to Debt Holders

 The differences in capital structure observed for Hilton Worldwide and Computer Sciences are not unique.
Hence, no ONE correct leverage for all
Similar differences are prevalent across most sets of businesses, either across or within industries.
Understanding the strong variation in policy continues to pose a challenge for researchers in this area.

Table 3. Median leverage ratios for U.S. industries in 2014.

Number of firms Book Leverage Market Leverage
Industry Debt to EBITDA
Pharmaceutical products 591 0.02 0.01 0.00
Metallic & ind. metal mining 123 0.07 0.07 0.00
Precious metals 123 0.09 0.05 0.00
Medical equipment 196 0.10 0.05 0.03
Agriculture 26 0.13 0.11 0.42
Computers 141 0.14 0.06 0.51

Beer and liquor 22 0.32 0.17 2.26

Automobiles and trucks 87 0.33 0.19 1.42
Construction materials 80 0.36 0.19 2.52

Transportation 180 0.46 0.32 3.44

Health care 78 0.47 0.24 3.12
Entertainment 75 0.52 0.32 3.73
Communication 166 0.54 0.32 2.91
Real estate 72 0.54 0.30 5.85
Utilities 122 0.54 0.39 4.04
Data source: Created by author using Compustat data organized by the Fama-French 48 industries classification.

Source: Management of Financial Policy Decisions: Capital Structure Policy

To illustrate, Table 3 reports the median leverage ratios in 2014 for selected industries (the industries with
 the tendency for high asset tangibility, large profits, low profit volatility, or low potential for growth
opportunities. In contrast, firms within the pharmaceutical industry or the commodity-based industries of
Even within the same industry
mining, metals, or agriculture might have low levels of debt due to the tendency for low asset tangibility, small
profits, high profit volatility, or high potential for growth opportunities.

Table 4. Leverage ratios for the beer and liquor industry in 2014.

Industry Book Leverage Market Leverage Debt to EBITDA

Crimson Wine 0.00 0.00 0.00
Big Rock Brewery 0.00 0.00 0.00
Boston Beer 0.00 0.00 0.00
AmBev 0.06 0.01 0.16
MGP Ingredients 0.09 0.04 0.50
Eastside Distilling 0.10 0.00 NA
Craft Brew Alliance 0.11 0.06 1.04
Compania Cervecerias 0.15 0.08 4.07
Willamette Valley Vineyard 0.21 0.16 NA
Molson Coors Brewing 0.29 0.19 1.00
Castle Brands 0.30 0.04 2.84
Brown Forman 0.33 0.05 3.08
Vina Concha Y Toro 0.36 0.22 4.48
Kirin Holdings 0.42 0.37 2.78
China New Borun 0.47 0.88 3.01
Heineken 0.49 0.26 NA
Anheuser-Busch 0.51 0.22 2.74
Truett-Hurst 0.56 0.40 3.01
Diageo 0.58 0.17 2.74
Constellation Brands 0.58 0.31 5.30
Data source: Created by author using Compustat data.
Source: Management of Financial Policy Decisions: Capital Structure Policy
As a basis of comparison, Table 3 also includes a few of the industries with middle-of-the-road median
Factors
Page 14influencing CFO’s decision on capital structure
UV7078

Table 5. Survey results for “What factors affect how you choose the appropriate amount of
debt for your firm?”
Important or
Factor Example
Very Important
Financial flexibility We restrict debt so we have enough internal funds available to
pursue new projects when they come along 59%

Credit rating Our credit rating as assigned by rating agencies 57%

Cash flow volatility The volatility of earnings and cash flows 48%

Tax shields The tax advantage of interest deductibility 45%

Transaction costs The transaction costs and fees for issuing debt 34%

Comparables The debt levels of other firms in our industry 23%

Direct financial The potential costs of bankruptcy, near-bankruptcy, or financial 21%

distress costs distress

Indirect financial We limit debt so our customers/suppliers are not worried about 19%
distress costs our firm going out of business

Source: Created by author based on John R. Graham and Campbell R. Harvey.

Source: Management of Financial Policy Decisions: Capital Structure Policy
What to model?
• In addition to the valuation model, It would be sensible to check

• Understand the risks and drivers underpinning the business

• Consider sustainability of recurring income, asset base, volatility, cash flow

• Debt ratios ie, D/E, Debt/EBITDA, Interest Coverage (EBIT/Interest), etc. These
changes the Cost of Debt which changes Beta which changes ROE…

• Sensitivity analysis on valuation due to change of capital structure

• EPS, ROE, synergies assumptions

• Financial flexibility is the KEY!!

 Lev: $270,000 = $270,000 +
Nolev: $270,000 = $270,0
Debunk common capital structure fallacies
Source: Created by author.

• The
Fallacy 1 – Equity insightthan
is cheaper from this
Debt example is that leverage amplifies risk and
• possibility
Just because debt of
hastempting
an explicit upside gains,
interest cost andone also
equity accepts
does the
not have an possibility
explicit of
Leverage
dividend creates
rate, equity both dazzling upside gains as well as equally dazzling
is not cheaper
amplifies the outcome for the equity holder.
• Fallacy 2 – Debt is always cheaper than equity
•
Nolev’s argument for how debt amplifies returns is evident in a simp
Debt provider moves business risk to equity holder who will therefore seek higher
return ratio,
on theirreturn on equity
increased (ROE).
risk stake. ROE,
Nothing comesdefined
free as profit divided by
equity,
get on their investment. ROE can be artfully decomposed into two te
•
leverage, as shown in Equation 3.
Fallacy 3 – Financial leverage creates great investment opportunities
• Leverage amplifies downside as well
• It only works well to shareholder if ROA is +ve

To see how the decomposition works, one must recognize that the v
Week 3 exercise

Case Study – Burton Sensors Case Study

• Ensure Week 1 & 2 exercises are fully completed before starting Week 3 exercise
• Financial Analysis of Burton – Assess its performance and understand the underlying
issues
• 3x proformas on 3 proposed scenarios:
– Burton purchase Thermowell with new stock placement
– Merged proformas (Burton + EE) based on EE’s owner indication and without
acquisition of Thermowell
– Merged proformas (Burton + EE) and the acquisition of Thermowell
Week 3 exercise (tips)

• Complete Week 3– Fin Analysis before attempting 3x proformas

• Then, use Week 3 – Fin Analysis as the base (copy & paste to Week 3-Burton(New
Stock + Thermo)
• For scenario: Burton purchase Thermowell with new stock placement:
– Add cells (or rows) for inputs to adjust the relevant variables in 3-way financials (ie,
savings & investments from Thermowell, change in equity from Issuing new stock)
– The 50k additional shares for placement fee is a give away – does not add to equity
on B/S
– Can assume all the increase in NWC to be split 50/50 to AR and inventory
– Debt schedules would change due to equity injection – model proforma so that the
2017 proforma cash balance to be unchanged at $371.3
• Once all done, check the ratios
Week 3 exercise (tips)

• Merged proformas (Burton + EE) based on EE’s owner indication and without acquisition
of Thermowell
– Combine Burton Proforma (use Week 3 – Fin Analysis) and Week 1 – Electro Eng
Proforma (from 2016 onward). All lines of statements are direct addition of both
companies except for equity to form post acquisition proforma
– In M&A, target’s equity will be cancelled. The acquiror’s equity (post acquisition) will
be boosted by the amount of equity issued for the acquisition. Ie, 10x 2016 EBITDA
in Burton’s case study
– The acquisition consideration minus the target’s equity will be goodwill on the asset
side of the Balance Sheet

• Again, check the ratios

Week 3 exercise (tips)

• Merged proformas (Burton + EE) and the acquisition of Thermowell

– Using the same input cells you created in the 1st scenario (Burton + Thermowell)
– Add to the 2nd scenario (Burton + EE) that you just completed.

• Check ratios

• Check/ Compare the ratios across all three scenarios