Charles Raymond, the CEO of Raymond Aluminum Products, is concerned about his firms level of debt financing.

The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other firms in the aluminum industry generally have between 25 and 35 percent of their long-term capitalization in debt, and Charles Raymond wonders if this difference should continue, and what effect a movement toward a greater use of debt have on the companys earnings and stock price. Because Charles Raymond has no firm grounding in Capital Structure Theory and because he would like to understand the situation he has prepared a list of questions that he would like to have answers of. This is the task we, the CFI 619 Class of Summer 2012 at CUEA, have been assigned.

Q.1 a. What is a firms capital structure? What is its capitalization? b. What is capital structure theory? Answer: a. A firms capital a structure is the mix of debt and and a equity firms

financing it uses. It is also referred to as its capitalization. Therefore, firms capital structure capitalization are two terms that can be used equivalently. b. Capital structure theory is a body of knowledge in Finance and Economics that seeks to explain if a firm could maximize its value or if it- the firms value, is affected by using a certain combination of debt and equity financing, what is referred to the optimal capital structure.

Q.2 a. Who are Modigliani and Miller (MM)? b. List the assumptions of MMs no-tax (1958) model.

c. What were the two main propositions MM developed in their no-tax model? State the propositions algebraically, and discuss their implications. d. Describe briefly how MM proved their propositions.

Answer: a. Franco Modigliani and Merton H. Miller are two Nobel laureates who contributed greatly to the subject of Financial Economics. Their main contributions were: (i) in economics expanding on the thoughts of of Milton Keynes by explaining F. & how the real R., economy is connected to the monetary economy; the life cycle hypothesis consumption (Modigliani, Brumberg, 1953/54); and (ii) in finance the Modigliani-Miller theorem which marked the beginning of the modern theory of finance, the subject of this case study. Some of their works include: Franco Modigliani and Merton H. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, June 1958, 261-297; The Cost of Capital, Corporation Finance and the Theory of Investment: Reply, American Economic Review, September 1958, 655-669; Taxes and the Cost of Capital: A Correction, American Economic Review, June 1963, 433-443; and Reply, American Economic Review, June 1965, 524-527. b. Assumptions The following are the assumptions that were made initially: 1. Business risk can be measured by EBIT, and firms with the same degree of business risk are said to have future be in a homogeneous risk class. 2. All present and prospective homogeneous expectations about

investors expected

identical corporate

estimates of firms future EBIT; that is, investors have earnings and the riskiness of those earnings. 3. Stocks and bonds are traded in perfect capital markets. This assumption implies among other things, (a) that there are no brokerage costs 2 and (b) that investors (both

individuals and institutions) can borrow at the same rate as corporations. 4. The debt of firms and individuals is riskless, so the interest rate on debt is the risk-free rate. Further, this situation holds regardless of individual) uses. 5. All cash flows are perpetuities; that is, the firm is a zero growth firm with an expectationally constant EBIT, and its bonds are perpetuities. Expectationally constant means that investors expect EBIT to be constant, but after the fact, the realized level could be different from the expected level. c. Propositions I. The value of any firm is established by capitalizing its net operating income (EBIT) at a constant rate based on the firms risk class: VL = VU = (EBIT / WACC) = (EBIT / ksU) Where L levered firm U unlevered firm VL = value of levered firm VU = value of unlevered firm ksU = required rate of return for an unlevered firm From VL = VU, then under the MM model, when there are no taxes, the value of the firm is independent of its leverage. The implications are: 1) That the weighted average cost of capital to any firm is completely independent of its capital structure, and 2) That the WACC for any firm, regardless of the amount of debt it uses, is equal to the cost of equity it would have if it used no debt. 3 how much debt a firm (or

II.

The cost of equity to a levered firm, ksL, is equal to (1) the cost of equity to an unlevered firm in the same risk class, ksU, plus (2) a risk premium whose size depends on both the differential between an unlevered firms costs of debt and equity and the amount of debt used: ksL = ksU + Risk premium = ksU + (ksU kd)(D/S) Where D = market value of the firms debt S = market value of the firms equity kd = constant cost of debt ksL = cost of equity to a levered firm ksU = required rate of return for an unlevered firm Proposition II states that as the firms use of debt increases, its cost of equity also rises, and in a mathematically precise manner. The implication is: when the two MM propositions are considered together, they show that addition of more debt in the capital structure will not increase the value of the firm, because the benefits of cheaper debt will be exactly offset by an increase in the riskiness, hence in the cost, of its equity. Thus, MM state that in world without taxes, both the value of a firm and its overall cost of capital are unaffected by its capital structure.

d. MMs Arbitrage Proof MM used an arbitrage proof to support their propositions. They showed that their assumptions, if two companies differed only (1) in the way they are financed and (2) in their total market values, then investors would sell shares of the higher-valued firm, buy those of the lower-valued firm, and continue this process until the companies had exactly the same value.

Q.3 Using Raymond Aluminums projected 1990 EBIT of $1.5 million, and assuming that MMs conditions hold, we can compare Raymonds value as unlevered firm (Vu) with the value the firm would have under the MM notax model, if it had $5 million of 10 percent debt (V L). a. What are VU, VL, and ksL? b. Use the WACC formula to find Raymond Aluminums WACC if it used debt financing. c. Use the formula WACC = EBIT / V to verify that WACC is 15 percent when the firm uses financial leverage. d. Graph the MM no-tax relationships between capital costs and leverage, plotting D / V on the horizontal axis. Also, graph the relationship between the firms value and D / V.

Answer: a. ksU = 15% = 0.15, kd = 10% = 0.10, EBIT = $1500000 (From case information) I. Unlevered DU = $0 Let the value of Raymond Aluminum Stock be S U: SU = (EBIT - kdD) / ksU = ($1500000 - $0) / 0.15 = $10000000 Let the total market value Raymond Aluminum be V U: VU = VL = DU + SU = $0 + $10000000 = $10000000 II. Levered DL = $5000000 Let the value of Raymond Aluminum Stock be S L: DL + SL = VL SL = VL DL = $10000000 - $5000000 = $5000000

III. ksL ksL = ksU + (ksU - kd)(D/S) = 15.0% + (15.0% - 10.0%)($5000000/$5000000) = 15.0% + 5.0% = 20.0%

b. WACC = wdkd + wceksL = (D/VL)kd + (SL/VL)ksL = ($5000000/$10000000)(10.0%) + ($5000000/$10000000)(20.0%) = 5.0% + 10.0% = 15.0% c. From Propositon I , Raymond Aluminums WACC = k sU = 15.0% VU = VL = EBIT / WACC = EBIT / ksU ksU = EBIT / VU = $1500000 / $10000000 = 0.15 = 15% d. (i) Figure 1: Without Taxes 50 Vertical axis: Cost of capital (%) 40

30 ksL 20 WACC

10 Horizontal axis: Debt / Value Ratio (%) 0 20 40 60 80 100

(ii) Figure 2: Plot of Debt vs. Value 50 Vertical axis: Value of Firm, ($ in millions) 40

30

20 Firm Value, VL = VU = $10000000 10 Horizontal axis: Debt ($ in millions) 0 20 40 60 80 100

Interpretation: Figure 1 plots Capital Costs against leverage as measured by the Debt / Value ratio. Note that, under MM No-Tax assumption, kd is a constant 10 per cent, but ksL increases with leverage. Further, the increase in ksL is exactly sufficient to keep the WACC constant. The implication is: the more debt the firm adds to its capital structure, the riskier the equity and thus the higher its cost. Figure 2 plots the firms Value against Leverage (Debt). With zero taxes, MM argue that value is unaffected by Leverage, and thus the plot is a horizontal line. (Note at D / V = 100%, the Debtholders become the firms owners.)

Q.4 Now consider MMs later (1963) model, in which they relaxed the no-tax assumption and added corporate taxes. a. What are their new Propositions I and II? b. Repeat the analysis in Question 3 under the assumption that both the levered and unlevered firm would have a 40 percent tax rate.

Answer: In 1963 MM published a second article which included corporate tax effects. With corporate income taxes, they concluded that leverage will increase a firms value. This occurs because interest on debt is a tax-deductible expense, hence more leveraged firms operating income flows through to investors. a. Propositions I. The value of a levered firm is equal to the value of an unlevered firm in the same risk class (V U) plus the gain from leverage. The gain from leverage is the value of the tax savings, found as the product of the coporate tax rate (T) times the amount of debt the firm uses (D): VL = VU + TD Where D = amount of debt firm uses T = corporate tax rate VL = value of levered firm VU = value of unlevered firm The equation shows that when corporate taxes are introduced, the value of the levered firm exceeds that of the unlevered firm by the amount TD. Note: The firms value is maximized at 100% debt financing. 8

For the un-levered firm, when D = $0, the value, V U, is given by: S = VU = EBIT (1 T) / ksU Therefore the firm value, VU, is the same as its equity. II. The cost of equity to a levered firm is equal to (1) the cost of equity to an unlevered firm in the same risk class plus (2) a risk premium whose size depends on the differential between the costs of equity and debt to an unlevered firm, the amount of financial leverage used, and the corporate tax rate: ksL = ksU + (ksU kd)(1 T)(D/SL) Where D = amount of debt firm uses T = corporate tax rate S = market value of the firms equity kd = constant cost of debt ksL = cost of equity to a levered firm ksU = required rate of return for an unlevered firm Since (1 T) is less than one, the imposition of corporate taxes causes the cost of equity to rise less rapidly than was in the absence of taxes. This effect does change what is established in Proposition I: that the firms value increases as its leverage increases.

b. I.

EBIT = $1500000; T = 40% = 0.40; Unlevered DU = $0 VU = EBIT (1 T) / ksU = $1500000 (1 0.40) / 0.15 = $6000000 II. Levered DL = $5000000 VL = VU + TD = $6000000 + 0.40($5000000) = $8000000 9

III. ksL D + SL = VL SL = VL D = $8000000 - $5000000 = $3000000 ksL = ksU + (ksU kd)(1 T)(D/SL) = 15% + (15% - 10%)(100% - 40%)($5000000 / $3000000) = 20% IV. WACCL = (D/VL)kd(1 - T) + (SL/VL)ksL = ($5000000 / $8000000)(10%)(100% - 40%) + ($3000000/$8000000)(20.0%) = 3.75% + 7.50% = 11.25% V. Figure 3: With Taxes 50 Vertical axis: Cost of capital (%) 40

30 ksL 20 WACC 10 kd(1-T)

20

40

60

80

100

Horizontal axis: Debt / Value Ratio (%) Interpretation: Figure 3 shows the WACC falls continuously as the firm uses more and more debt, whereas the WACC was constant in Figure 1. This

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result occurs because of the tax deductibility of debt financing (interest payments), which impacts the graph in two ways: (1) the cost of debt is lowered by (1-T), and (2) the cost of equity increases at a slower rate when corporate taxes are considered because of the (1-T) term in Proposition II. The combined effect produces the downward sloping WACC curve. (ii) Figure 4: Plot of Debt vs. Value 150 Vertical axis: Value of Firm, ($ in millions) 120 VL = VU + TD 90 TD

60

30

VU

20

40

60

80

100

Horizontal axis: Debt ($ in millions) Interpretation: Figure 4 shows that, when corporate taxes are considered, the firms value increases continuously as more debt is used.

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Q.5 Miller, in his 1976 Presidential Address to the American Finance

Association, added personal taxes to the model. a. What is Millers basic equation (his Proposition I)? b. What happens to Millers model if there are no corporate or

personal taxes? What happens if only corporate taxes exist? c. Now assume that Tc = Corporate tax rate = 40%, T d = Personal tax rate on debt income = 28%, and T s = Personal tax rate on debt income = 20%. What is the gain from leverage according to the Miller model? How does this compare with the MM gain from leverage, where only corporate taxes are considered? d. What generalizations can we draw from the Miller model regarding the value to a corporation of using debt when personal taxes are considered?

Answer: a. Millers 1976 Proposition With personal taxes included, and under the same set of assumptions used in the earlier MM models, the value of an unlevered firm, VU, is: VU = EBIT(1-Tc)(1-Ts) / ksU Where Tc = corporate tax rate Ts = weighted average of effective tax rates on dividends and capital gains ksU = required rate of return for an unlevered firm Since the introduction of personal taxes lowers the income available to investors, personal taxes reduce the value of the unlevered firm, other things held constant.

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b. Millers Model states VL as follows: VL = VU + (1 ((1-Tc)(1-Ts) / (1-Td)))D Where Tc = corporate tax rate Td = Personal tax rate on debt income Ts = Personal tax rate on debt income From the Miller Model: 1. if all taxes are ignored, that is, Tc = Ts = Td = 0, then this term: (1 ((1-Tc)(1-Ts) / (1-Td))) = 0; 2. if personal taxes are ignored, that is, T S = Td = 0, then this term: (1 ((1-Tc)(1-Ts) / (1-Td))) = Tc; 3. if Ts = Td, then (1-Ts) = (1-Td), and therefore this term: (1 ((1-Tc)(1-Ts) / (1-Td))) = Tc; 4. if (1-Tc)(1-Ts) = (1-Td), then this term: (1 ((1-Tc)(1-Ts) / (1-Td))) = 0 This implies that the tax advantage of debt to the firm would be exactly offset by the personal tax advantage of equity. Under this condition, capital structure would have no effect on a firms value or its cost of capital, which would imply MMs original zero-tax theory. c. Use Millers Model: d. VL = VU + (1 ((1-Tc)(1-Ts) / (1-Td)))D I. If Ts = 40%, Td = 28%, and Ts = 20%, then Millers Model becomes: VL = VU + (1 ((1-0.40)(1-0.20) / (1-0.28)))D = VU + 0.333333D

The firms value when levered and all taxes are considered would increase by an additional third of the debt used.

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II.

If corporate taxes only are used, then VL , is given by: VL = VU + TD = VU + 0.40D The gain in value appears to be more when only corporate taxes are considered.

d. The above workings show that the addition of personal taxes lowers the value of debt financing to the firm. Q.6 What are the implications of the three theories (MM no tax, MM with corporate taxes, and Miller with corporate and personal taxes) for financial managers regarding the optimal capital structure? Do firms appear to follow one of these theoretical guidelines consistently?

Answer: I. With zero taxes, the MM Theory says that capital structure is irrelevant, that is, that it has no impact on the value of the firm. It in effect says: one capital structure is as good as another. II. With corporate but not persona taxes considered, the MM Model states that firm value increases continuously with financial leverage, and hence firms should use (almost) 100 percent debt financing. III. MM Model with personal taxes included implied the value of debt to the firm reduced slightly but debt was still important in a firms capital structure. The model did not change the impression that companies would increase their net worth, VL, by using more and more debt. IV. There was a trend initially where companies were increasing their debt. But this trend changed in the 1990s and firms seem to have come to a consensus that an optimal capital

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structure would be that having approximately 40% debt in its mix.

Q.7 How does the addition of financial distress and agency costs change the MM (with corporate taxes) model and the Miller model? (Express your answer in both equation and graphical forms, as well as discuss results.) Answer: MM (with corporate taxes) model and the Miller model with agency costs added: In equation form, it is stated as follows: VL = VU + TD (PV of expected costs of financial distress) (PV of agency costs) From the equation, it can be seen that when financial distress and agency costs are added, the use of leverage is a trade-off between the tax benefits of debt financing and the risk-related costs.

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Figure 5: Net Effects of Leverage on the Value of the Firm 25 Vertical axis: Value of Firm, ($ in millions) 20 VL = VU + TD Pure MM value of Firm 15

10

VU Financial Distress and Agency Costs

05 Actual value of Firm 0 A 40 60 B 80 100 100

Horizontal axis: Debt ($ in millions) TD: Present Value of Interest Tax Shelter Interpretation: The tax shelter effects totally dominate until the amount of debt reaches point A. After point A, financial distress and agency costs become increasingly important, offsetting some of the tax advantages. At point B, the marginal tax shelter benefit of additional debt is exactly offset by the disadvantages of debt, and beyond Point B, the disadvantages outweigh the tax benefit. The addition of financial distress and agency costs to either the miller model results in a trade-off model of capital structure. In such a model, the optimal capital structure can be visualized as a trade-off between the benefit of debt (the interest tax shelter) and the costs of debt (financial distress and agency costs).

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Q.8 Briefly describe the asymmetric information theory of capital

structure. What are the Implications for financial managers?

Answer: The asymmetric information (signaling) theory recognizes that mangers typically know more about a firms prospects than do investors. Thus, investors view managerial action as signals. Since managers will only issue new common stock when no other alternatives exist or when the stock is overvalued, investors view common stock sales as a negative signal and the stock price falls. Managers do not want to trigger a price decline, so a reserve borrowing capacity is maintained. Q.9 Now prepare a summary of the implications of capital structure theory which can be represented to Charles Raymond. Consider specifically these issues: (a) Are the tax, trade-off, and asymmetric information mutually exclusive? (b) Can capital structure theory be used to actually establish a firms optimal capital structure with precision? If not, then what insights can capital structure theory provide managers regarding the factors which influence their firms optimal capital structures?

Answer: a. The tax, trade-off, and asymmetric information theories are not mutually exclusive: they dependent on each other, as is illustrated in Figure 5, and as is shown by the existence of more than one of the MM and Miller propositions- basically could as proof there is correlationship between all the three theories. b. Research after research has established that no formula exists that could precisely predict an exact optimal capital structure for a firm. Thus the general consensus that maintaining capitalization with debt of around 40% would provide a firm with optimal results. That prediction is impossible, or very

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difficult, is also explained by the all MM and Miller models which predict different results simultaneously. Professor Gordon Donaldson has said the following of what insights the capital structure theory can provide: 1. Firms prefer to finance with internally generated funds that is with retained earnings and depreciation cash flow. 2. Firms set target dividend payout ratios based on their expected future investment opportunities and their future cash flows. The target payout ratio is set at a level such that retained earnings plus depreciation will cover capital expenditures under normal conditions. 3. Dividends are sticky in the short run firms are reluctant to raise dividends unless they are confident that the higher dividend can be maintained, and they are especially reluctant to cut the dividend. Indeed, they generally do not reduce the dividend unless things are so bad they have to. 4. If a firm has more cash-flow than is needed to cover its expenditures, then it will invest in marketable securities, use the funds to retire debt, increase dividends, or repurchase stock... Gordon Donaldson, Corporate Debt Capacity: A Study of Corporate Debt Policy and the Determination of Corporate Debt Capacity (Boston: Harvard Graduate School of Business Administration, 1961) Conclusion: Deciphering Prof. Gordon Donaldson While Capital Structure theories point to debt as being a positive driver of the firm value, Charles Raymond will be well advised to consider the insights that Professor Gordon points to: for example, he should determine growth stage of Raymond Aluminum Products, examine its cash flows which are healthy, consider alternative investments marketable securities, and revisit the companys dividend policy renegotiate the policy to increase retained earnings, for the positive prospect of using internal funds for financing. Opler, et al. (1997) have gone further and stated the benefits a firm gets when it adds debt to its capital structure. These benefits are: 18

a) that heavy use of debt is likely to produce efficiency gains in companies with abundant free cash flow that dont require much additional capital to fund investment requirements; b) that in such cases, substituting debt for equity is likely to add value by strengthening managements incentive to increase future cash flow and return excess capital to investors; and c) that, taxes also provide an important and quantifiable benefit of debt financing. In particular, interest payments to debt-holders are tax deductible while dividend payments to equity-holders are not. This gives a clear reason for firms to borrow rather than issue equity (at least up to the point where a firm still has income taxed at a high marginal rate). Therefore use of debt is advised in this case. References I. Brigham, E. F., & Gapenski, L.C., Financial Management: Theory and Practice, The Harcourt Brace College Publishers, London, UK, 619 -642 Opler, T. C., et al. (1997) Designing Capital Structure to Create Value, Journal of Applied Corporate Finance, Volume 10, Number 1, Spring 1997, 21-32 http://www.csub.edu/~kshakoori/courses/FIN-600/ http://www.csub.edu/~kshakoori/courses/FIN-600/lectures.htm

II.

III. IV.

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