Creating Shareholder Value Through Capital Structure Optimization

By Matthew R. Morris, CFA

Introduction
In the wake of the recent and dramatic market declines, we have seen a resurgent emphasis placed on firms to create shareholder value. This focus on shareholder value is certainly nothing new. Over the years, firms have implemented countless programs designed to increase shareholder value. From Stern Stewarts Economic Value Added (EVA) to complex and sometimes confusing strategy consulting, measurements and policies have been put in place to increase returns to shareholders. However, lost in the corporate finance jungle, caught somewhere between theory and practice, is a very important and applicable tool that can assist managers create value for shareholders optimal capital structure analysis. In order to appreciate any discussion relating to optimal capital structure analysis, one should be familiar with a fundamental tenet of modern finance: the value of a firm is equal to the present value of the net cash flow it is expected to generate. Accepting this as true, the relationship inherent in this statement is that, holding cash flow constant, the value of a firm can be increased by minimizing the rate used to discount its cash flow to present value its cost of capital (commonly referred to as weighted-average cost of capital, or WACC). This relationship between firm value and WACC (disregarding growth rates) is graphically illustrated below in a one-period model:

Decoupling the Cost of Capital

Before exploring the finer points of capital structure analysis, it is useful to understand the characteristics of a firms WACC. A firms WACC is a function of two primary components: (1) the cost of the equity capital (K e ) and debt capital (K d ) that a firm employs as well as (2) the mix of equity capital and debt capital used to finance a firms operations. Given the mix of equity and debt capital and the costs associated with each, a firms WACC is simply a weightedaverage function: WACC = (We x Ke )+ (Wd x Kd ) (2)

where We and Wd equal the proportions of equity and debt capital, respectively, used to fund a firms operations. There are several ways to determine a firms Ke, but generally the cost of equity is related to the relative risk associated with an investment in the firm as well as the returns available on other investments. Conversely, a firms Kd is a function of its ability to cover its debt obligations as well as the value and liquidity of any collateral offered to secure the debt. This type of analysis is resident in the right side of the balance sheet (sources of capital), but analyzing it from the left side of the balance sheet (uses of capital) can tell an interesting story about the required rates of return on a firms assets. A firms assets can be broadly divided into three categories: (1) working capital assets, (2) tangible (or fixed) assets and (3) intangible assets. Each asset class is expected to earn some rate of return that on a weighted-average, aggregate basis meets or exceeds the firms overall WACC. For example, suppose Firm ABCs assets equal $100 million comprised of $20 million in working capital assets, $30 million in fixed assets and $50 million of intangible assets. Furthermore, suppose the required rate of return for the working capital assets (Kwc) can be estimated at 5.0%, the required rate of return for its tangible assets (Kta ) can be estimated at 10.0% and that Firm ABCs overall WACC is empirically estimated at 14%. Simple algebraic manipulation

Firm Value

Cash Flow WACC

.

(1)

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yields a required rate of return for intangible assets (Kia ) of 20.0% by rearranging equation (2):
Kia = WACC (Wwc x Kwc + W ta x Kta) / W ia Kia = 0.14 (0.20 x 0.05 + 0.30 x 0.10) / 0.50 Kia = 0.20 = 20.0%

The nave approach would be to assume that because debt capital is generally regarded as less expensive than equity capital, a company should try to fund its operations with as much debt as possible. Such an arrangement would theoretically produce the following set of return curves:
Expected Rate Of Return

Understanding the nature and relationship of WACC to both the sources (debt and equity) and uses (asset selection) of capital is essential to formulating sound capital structure policy.

Optimal Capital Structure Analysis

The capital structure decision is primarily a function of three factors: (1) asset selection, (2) debt/equity mix selection and (3) dividend payout policy. While these factors should be considered simultaneously, it often happens that asset selection occurs fi rst, with debt/equity mix selection and dividend payout policies being decided upon later. Regardless of the decision order, these factors create a flow of funds depicted in the following illustration:

Ke

Nave WACC Kd Debt/Capital Ratio

10 %

20 %

30 %

40 %

50 %

60 %

70 %

Nave Optimal Capital Structure

Tax Authority
Ta

ASSETS
xes

EBIT
se pen Ex Ne t

Debt Equity

This illustration reflects the erroneous assumption that the costs of debt and equity are static and therefore do not change with changes in capital structure. If this were feasible, then every company would finance its operations with little or no equity capital. Of course, market observations tell us that this is simply not feasible due to default and bankruptcy risks. Because equity is already the residual claim after all other claims (such as debt), by increasing the debt ratio of a companys capital structure, the risk associated with the equity return greatly increases. This leverage effect acts to produce a cost of equity that rises with debt/capital ratio. In fact, equity investors are not the only ones that face higher risk at higher debt-to-capital levels. Debt investors also feel the pressures that high debt obligations place on the recoverability of their investments. Companies with high debt-tocapital ratios typically have a higher Kd than do their less leveraged counterparts, as witnessed in debt rating services such as Standard & Poors and Moodys. In fact, at extremely high leverage, debt investors face a remarkably similar set of investment risks as equity investors. As a result, the upper limit rate of return on the lowest-grade

Interest

Income Dividends/Capital Gains Shareholders

Notice how the net income, interest expense and taxes are divided among the firms various stakeholders. A companys optimal capital structure is therefore the specific debt/equity mix that maximizes the companys overall value (i.e. the size of the debt/equity pie in the above illustration). The trick then becomes as simple as to isolate what Ke and Kd are at different debt-tocapital ratios.

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corporate debt will approximate equity rates of return, creating the following set of return curves:
Expected Rate Of Return

Having created the framework for calculating Ke, the calculation of Kd is required to complete the analysis. The yield required of debt is generally a function of default risk, which can be proxied by bond ratings derived through the calculation of various financial ratios. For example, according to recent S&P ratings criteria, industrial companies rated as having AAA debt generally exhibited the following characteristics: EBIT Coverage: EBITDA Coverage: Funds From Ops/Total Debt: Free Cash Flow/Total Debt: Return on Avg. Capital: EBIT Margin: Long-Term Debt/Capital: Total Debt/Capital: 17.5 times 21.8 times 105.8 % 55.4 % 28.2 % 29.2 % 15.2 % 26.9 %

Ke

WACC Kd

B BBB AAA A

10 %

20 %

30 %

40 %

50 %

60 %

70 %

Debt/Capital Ratio

Optimal Capital Structure

Understanding this relationship between rates of return and financial leverage, the task of optimizing the firms capital structure turns to the estimation of debt and equity returns at various debt levels.

Knowing the relationship between the leverage effect on Ke and the Kd of various grades of debt, the choice of optimal capital structure becomes a simple solution. Again suppose Firm ABC had a market value of capital equal to $100 million at a debt-to-capital ratio of approximately 10%. Assuming the following parameters: the firm pays taxes at an effective rate of 40%, the yield on a U.S. Treasuries (Rf ) is 6.0%, the excess return premium (Rm) is approximately 8.0% and the companys unlevered beta ( U) equals 0.90, the firms cost of equity is calculated under CAPM using equation (3) as: Ke = 6.0% + (0.96 x 8.0%) Ke = 13.7% Repeating this calculation at various debt-tocapital ratios yields the following table:

Calculating Ke and Kd
To determine Ke, we will use the Capital Asset Pricing Model (CAPM): Ke = Rf + (L x Rm) (3)

where Rf equals the yield of risk-free investments (such as on U.S. Treasuries), L equals the firms levered beta (a measurement of relative investment risk) and Rm equals the excess return over Rf required to compensate for the risk of equity investing. Because Rf and Rm are relatively stable over the short- and medium-term, Ke becomes largely a function of L. Using this framework, an unlevered beta ( U) is calculated and used to estimate L at the various debt-tocapital ratios and effective tax rates (T): L = U x (1+ (1 T) x D/E) (4)

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Debt/Cap 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Debt 0 10 20 30 40 50 60 70 80 90

Equity 100 90 80 70 60 50 40 30 20 10

BL 0.90 0.96 1.04 1.13 1.26 1.44 1.71 2.16 3.06 5.76

Ke
13.2% 13.7% 14.3% 15.1% 16.1% 17.5% 19.7% 23.3% 30.5% 52.1%

10% debt-to-capital (therefore utilizing a WACC of 13.2% as previously calculated), by rearranging equation (1), the firms steady state, after-tax cash flow is expected to equal: Cash Flow = = = Firm Value x WACC $100million * 13.2% $13.2 million

Calculating the different debt ratings criteria for the firm at each debt-to-capital ratio can help determine the likely rating that debt would receive, and therefore the likely cost ( Kd ) and after-tax cost (Kd x (1-T) that debt will have:
Debt/Cap 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Debt Rating --AA A BBB B+ B CCC CC C D

Assuming that similar cash flow can be generated from the firms assets (and assuming identical effective tax rates), the new firm value under the optimal capital structure of 40% debt-to-capital can be calculated as: Firm Value = Cash Flow = $13.2 million WACC 12.1% Firm Value = $109.1 million Therefore, without changing any of the underlying business fundamentals, the firm is able to create approximately 9.1% in incremental value simply by borrowing $30 million and using the proceeds to repurchase existing shares from its shareholders. Notice that the firms overall cost of capital is not minimized by having the highest credit rating!

Kd
7.5% 7.8% 8.3% 9.0% 10.1% 11.5% 14.0% 16.0% 21.0% 23.0%

Kd x (1-T)
4.5% 4.7% 5.0% 5.4% 6.1% 6.9% 8.4% 9.6% 12.6% 13.8%

By synthesizing the K e and after-tax K d calculated at each debt-to-capital ratio, the lowest WACC is observed at approximately 40% debt-to-capital as seen below:
Debt/Cap 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Conclusion
Analyses such as this are simple in theory but far more difficult to undertake in the dynamic setting of a real business. Understanding the fundamental relationships between the amount, timing and risk of cash flow associated with business assets is important to creating value for shareholders, but no systematic value creation plan would be complete without optimizing the firms capital structure.

Ke
13.2% 13.7% 14.3% 15.1% 16.1% 17.5% 19.7% 23.3% 30.5% 52.1%

Kd x (1-T)
4.5% 4.7% 5.0% 5.4% 6.1% 6.9% 8.4% 9.6% 12.6% 13.8%

WACC
13.2% 12.8% 12.4% 12.2% 12.1% 12.2% 12.9% 13.7% 16.2% 17.6%

To complete the analysis, we need only calculate how much value Firm ABC has created by optimizing its capital structure. Assuming a market value of capital equal to $100 million at

Matthew Morris is Senior Manager at VALUE Incorporated, a premier firm in the practical application of valuation and economic theory. VALUE Incorporated provides value creation services to companies to fill the needs illuminated and discussed in this article. He can be contacted in the Dallas office at mmorris@valueinc.com The firm can be visited online at www.valueinc.com

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