Question

1.onsider what you feel would be an optional capital structure.

a.Would your recommendation differ depending on the type of industry? Why/why not?

b.What would you expect the impact to be on earnings per share (EPS) at an optimal capital structure? Is this impact important to you? Why/why not?

Answer 1

Capital Structure Across Industries

1. Introduction

1.1 Purpose of this Study

From the number of published papers concerning capital structure, it is apparent

that this is an important, difficult and complex subject. Every company would

like a capital structure which is best fitted to their current situation that minimizes

the cost of capital. Without good knowledge of the variables that control capital

structure, more insight about what might be the optimal debt ratio cannot be

revealed.

1.2 The Structure of this Study

The paper begins with a short presentation of the existing theory used as a theoretical

approach later in this text. Next, the capital structure hypothesis to be

addressed will be formulated, followed by an introduction to the background

information and methods used in the study. The main part of this paper starts

with a presentation of the descriptive statistics, followed by separate regressions

and the evaluations for the five industries studied. Subsequently, the pooled

regression with industry dummies is presented. The empirical part of this paper

ends with a pooled regression on the 50 largest companies in the sample. In the

conclusion the main results are discussed and areas for further research will be

suggested.

2. A Short Review

2.1 Existing Theory

In the first theorem from Modigliani and Miller (1958), that assumes a perfect

arbitrage free capital market, they claim that the value of a firm is independent of

the capital structure. Miller (1977) found a balance between supply and demand

of debt under both private and corporate taxes. Through an introduction of real

life market imperfections like tax, but also expected bankruptcy costs, Myers

(1984) claimed that the firm value is dependent on the debt ratio. This aspect of

the capital structure is known as the static trade-off theory, since companies

balance their debt ratio against bankruptcy costs and tax savings.

Another capital structure theory is the pecking order theory (e.g. described in

Myers (1984)). This theory is a funding hierarchy, explained by transaction and

issuing cost argumentation. A firm requiring capital for a new project will use its

retained earnings first. Then they should issue debt and lastly issue new equity.

The pecking order theory is also explainable using information asymmetry argumentation,

described in Ross (1977), Myers and Majluf (1984), and Harris and

Raviv (1990). The asymmetric information distribution between firm managers

and investors brings the signalling behaviour connected with capital structure

into focus (hidden information problem). Myers and Majluf’s model (1984)

explains that equity issues are known as a bad signal for investors, since they are

particularly lucrative for already overvalued companies. Hence, this theory

supports the pecking order funding hierarchy.1

Barclay and Smith Jr (1995) argue that the size of a firm will affect the capital

structure for two reasons: first, the fixed issuance costs for public issues are large,

resulting in a significant scale economy effect in favour of large firms. Second,

large firms are more likely to have foreign operations, and to manage their

currency exposure, they want to use foreign debt. As many non-US debt markets

are not that liquid, especially for long-term debt, large companies will use mostly

foreign short-term debt and hence influence the long-term debt ratio. These

hypotheses are contradictory, as we will point out later in the study.

The costs of debt and equity are not constant over time. According to von

Nitzsch and Rouette (2006), firms should finance their company with equity at

times when it is cheap compared to debt, and vice versa. Therefore, purely opportunistic

reasons also lie behind the capital structure.

As there is no model that summarizes all the theories concerning capital

structure into one, it is difficult to decide which theory that affects the capital

structure of each firm that is studied. There are many factors that affect a firm

simultaneously.

2.2 Empirical Studies

Since there are many complicated factors, economists are working to explain the

main driving factors behind the capital structure of firms. Welch (2004) introduces

a dynamic model where stock returns and net issuing activity explain most

of debt ratio changes. With a static view concerning company variables such as

turnover and profit, Barclay and Smith (2005) presents a review of the evidence

for a target capital structure.

The number of capital structure papers focusing on industrial sectors is relatively

small compared to other types of capital structure research. A paper from

MacKay and Phillips (2005) and an extensive paper from Fan et al. (2003) come

close to the problem we wish to address as they present the capital structure of

firms depending on the industries as well as several other variables. Hall et al.

(2000) have an industry and capital structure study of small- and medium-sized

unquoted enterprises (so-called SMEs) in the United Kingdom. We have used

their paper as a benchmark for our study, owing to the fact that the capital structure question of US publicly quoted companies, which are not expected to

experience the constrained pecking order, is a natural continuation of their work.

3. Capital Structure Hypotheses

3.1 Capital Structure and the Selected Industries

Every industry experiences its own set of economic conditions. For instance, if a

company is operating in an industry with very volatile earnings, it tends to have

more equity as a buffer against possible bankruptcy (Balakrishnan and Fox, 1993).

Additionally, industries are subject to different challenges within technology

development, environmental regulations, etc.

The construction industry is known as being sensitive to general market

conditions, since building projects are associated with high initial expenses.

Building plans are often cancelled in periods of economic downturn. The food

industry is assumed to be more stable, owing to the fact that food is a basic need.

Simultaneously, this is supposed to be an industry with relatively hard competition.

Oil and gas production is a capital-intensive industry with, at present, very

high operating margins. As a representative for a mature industry with a relative

neutral growth outlook, we have chosen the chemical industry. The information

technology (IT) industry is our representative for the new economy. The IT firms

have a relatively small amount of fixed assets compared to the other industries

(mostly human capital), and they have a strong market outlook. Titman (1984) has

shown that capital structure can be used to commit the investors to liquidate only

in those states where the net gain of liquidation exceeds the costs to customers.

The customer’s cost rises from the inability to obtain the product, parts or service

for already acquired products. The industry dummies may measure the extent of

interaction between product market characteristics and the debt levels. Firms

where this effect is pronounced, such as computer and automotive firms, are

expected to have less debt, ceteris paribus, than firms where this effect is less

important, such as industries with homogenous goods.

3.2 Hypothesis Formulation

Hall et al. (2000) find industry differences in unquoted small- and medium-sized

UK enterprises. In addition to significant variables from the capital structure

framework, we expect to find differences between industries in our study.

Through our empirical study, we want an answer to these hypotheses by means

of statistical hypothesis testing:

H0: There is no significant difference in capital structure between

industries.

H1: There is a significant difference in capital structure between

industries.

The null hypothesis, as every other statistic in this study, will be evaluated at a 5%

significance level. The determinants that drive the debt ratio, the various capital

market imperfection hypotheses and incomplete contracts theory, are by definition

unobservable. Agency costs of management cannot, for instance, be

measured directly. The other variables we use will in some cases contain several

hypotheses in each variable, for instance profitability will contain both the

bankruptcy cost hypothesis, documented by Warner (1977) and Andrade and

Kaplan (1998), and the free cash flow hypothesis of Jensen (1986). Both hypotheses

predict a positive relation between debt ratio and profitability. It will also

contain Myers and Mailuf (1984) asymmetric information hypothesis which

predict a negative relation between debt and profitability.

The size variable will likely contain both the asymmetric information hypothesis

and bankruptcy costs hypothesis, since a larger firm is more transparent and

less likely to go bankrupt. A more transparent firm will find equity capital less

costly, with reduced expected bankruptcy costs. It is therefore difficult to set up

conclusive a priori conjectures about predictions for the independent variables.

However, we can use previous studies like Hall et al. (2000) and Harris and

Raviv (1990) to predict the signs of the regression coefficients. As it is difficult to

decide which of the debt ratio factors connected with company size that is most

effective, there is uncertainty about the size sign. The predicted significant

coefficients are collateral (+), profitability (+/−), growth (−), size (+/−) or age (−).as

Capital Structure and Earnings Per Share

To this point in this book we have assumed that the capital structure

decision was made based on the joint interests of management and the

stockholders, and that a primary consideration was the effect of debt

issuance on the value of the firm. Thus we have made use of two value

formulations:

without investor taxes and with investor taxes:

Now we will shift to a focus on the effect of a change in capital

structure on the finn's EPS. The implication ofthe analysis is that high PIE

firms will tend not to issue debt because of the adverse effect of debt

issuance on the finn's EPS. Management should not make decisions based

solely on the effect on earnings per share (EPS) but the reality is that the

effect of a decision on EPS does influence choices that businesses make.

Will a capital structure change increase the firm's earnings per share?

The basic formulation for the effect ofsubstituting debt for equity

(with no investor taxes and no costs offinancial distress) is:

The value ofthe stock after the debt issuance is:

Since the debt proceeds are assumed to be distributed to the stockholders,

the total value ofthe shareholders' position after debt issuance is:

Total Wealth ofShareholders =S +B=VL

These formulations are based on the cash flow and earnings streamst

with and without debt. They are not based on the immediate effect of debt

issuance on EPS.

But assume that there is a value S· that is determined by the market

after the debt issuance and share repurchase and the S· is not necessarily

equal to S as determined above. Now the total shareholder wealth after

issuance is:

Total Wealth ofShareholders = S· + B

but now S· + B may not be equal to S + B as previously computed.

Appendix A shows that the EPS is decreased by debt issuance and

share repurchase if(l-te)kj is larger than EPS where P is the price paid for

P

the shares and EPS is the earnings per share before debt issuance.

Appendixes Band C show the derivation ofP, the stock price after

debt issuance. Since the debt issuance also increases ris~ the stockholders

who do not sell their shares will likely consider themselves to be harmed

(lower EPS and more risk) by the debt issuancet if the effect on EPS and

risk to common stock are the only two considerations.

Example

Assume N = ItOOOtOOO shares and Total Income = $8tOOOtOOO so

that EPS = $8; the stock can be purchased at $100.

EPS te=.35t kj =.10t -=.08t and(l-te)~=.065.

P

Since (l-te)kj is smaller than EPS we expect the debt issuance to be

P

beneficialt based on the EPS effect.

If$50tOOOtOOO of.10 debt is issued (500tOOO shares purchased) the

after tax cost ofinterest is $3t250tOOO. The new EPS is:

EPS = 8tOOOtOOO-3t250tOOO 4t750tOOO =$9.50

, ltOOOtOOO - 500tOOO 500tOOO

We have EPS = .08 is larger than (l-t)ki = .065 and EPS is increased by P

debt issuance and share repurchase from $8 to $9.50. The EPS increases

since E:S islarger than (l-te)kj•

We are not recommending that the capital structure decision be

based on the effect of debt issuance on EPS. However, it would be

surprising if management did not consider the effect of debt issuance on

EPS when the capital structure decision is being made.

A Changed Example: P =$200

Now assume the same facts except the stock can be bought at $200

and EPS =$8 so that EPS =.04 and now we expect that debt issuance will

P

not be beneficial based on EPS. Assume the stock price before consideration

ofdebt issuance and proposed share repurchase was $182.50.

If $50,000,000 of .10 debt is issued (250,000 shares purchased at a

price of$200), the after tax cost ofinterest is $3,250,000. The new EPS is:

EPS = 8,000,000 - 3,250,000 4,750,000 =$6.33

1,000,000 - 250,000 750,000

The EPS is reduced from $8 to $6.33 at the same time that risk is

increased by the substitution ofdebt for stock.

If the finn's EPS is smaller than (l-t)kj, the debt issuance will not

P

be desirable for the remaining shareholders (those who do not sell) from the

viewpoint ofthe changed EPS.

If all shareholders sold a pro-rata percentage oftheir stock, the debt

issuance might again be deemed desirable, but the tax authorities would

treat the distribution as a dividend, not a capital gain.

A Value Perspective

Assume that before the debt issuance the value ofthe firm (Vu) was

$182.50 (1,000,000) = $182,500.000. With $50,000,000 of debt, teD =

$17,500,000 and

VL =182,500,000 + 17,500,000 = $200,000,000.

The total value ofthe outstanding stock after the $50,000,000 debt

issuance is now:

S=VL - B=200,000,000 -50,000,000 =$150,000,000

The total value ofthe shareholders' wealth after debt issuance is:

Total Wealth ofShareholders =150,000,000 + 50,000,000 =$200,000,000

an increase of$17,500,000 over the value with no debt. The value per share

after debt issuance is:

150,000,000 =$200.00

750,000

up from $182.50 before the debt issuance. But the EPS calculations showed

a decrease in EPS from $8 to $6.33.

In theory, the analysis leading to the capital structure decrease

should be based on value, and not on the effect on EPS. When there is an

adverse effect for today's EPS, the firm's future growth will be spread over

fewer shares and the value will accrue to the 750,000 outstanding shares

rather than the initial 1,000,000 shares.

The Stock Value With Growth

Assume the stock price was $182.50 per share before debt issuance

and that 250,000 shares are purchased at a price of $200 per share. Before

debt issuance and share repurchase the owners of 750,000 shares not

repurchased would have a value of:

750,000 ($182.50) =$136,875,000

After the debt issuance and share repurchase these investors would

have a value of:

750,000 ($200.00) =$150,000,000

But the EPS would be decreased from $8.00 to $6.33.

Assume the dividend before debt issuance was $1, the cost ofequity

was .15 and the growth rate was .14452.

P= I $182.50

.15 - .14452

The $1,000,000 of dividends will grow to $14,900,000 in 20 years

(g = .14452) and the value of the ftrm will be $2,715,000,000. If the

$50,000,000 debt obligation grows at .065 (after tax) to be $176,000,000 the

stockholder value will be $2,539,000,000 for the remaining shareholders

versus .75 (2,715,000,000) = $2,036,000,000 without the debt.

The debt substitution is desirable from a value perspective even

though the EPS is initially decreased, if future growth of the ftrm is

considered.

The Relationship ofPo and p.

Ifthe stock is repurchased at a price of P =PI with B of debt, what

is the relationship ofPo and PI? Po is the initial stock price.

Appendix B shows that:

For the example, where Po = $182.50, teB = .35(50,000,000) =

$17,500,000, and N = 1,000,000 shares, the value ofPI is:

PI = 182.50 + 17,500,000 =182.50+17.50 =$200.00

1,000,000

This agrees with the calculation for the value per share that was

previously computed for this example.

Appendix C shows that ifthe stock is repurchased at a price of Po.

(rather than PI) that:

v - B(l-t ) P _ u c 1- B N--

Po

For the example if Vu =$182,500,000, Po = $182.50 and B =

$50,000,000 we have:

PI = 182,500,000 - 50,000,000(.65) 150,000,000 $206.60

1000000 _ 50,000,000 726,027

" 182.50

The ex-post price is larger since the 273,973 shares are purchased at

a lower price of$182.50 (rather than $200.00 per share).

EPS Targets

Each calendar quarter, security analysts estimate the EPS of firms

and the CFO's ofthese firms then tend to try to have their firms meet the

targets to avoid a threat to their stock prices.

If a firm will be slightly short ofthe target it can implement a debt

issuance, share repurchase strategy, before the end ofthe quarter.

Example

X = $153.85 and $153.85 (1-~) = $100, N = 50, EPS = $2, tc = .35,

P=$20

Assume the target EPS is $2.10 and the CFO does not want to

disappoint the analysts. With no actions the firm will earn $2 per share.

Assume $400 ofdebt can be issued to yield .08. The interest is $32

and the debt proceed can be used to buy 20 shares. The new EPS is:

EPS = (153.85 - 32)(1-.35) =79.20 =$2.64

50-20 30

The $2.10 target is easily met.

Ifthe debt is issued near the year end so that the interest for the year

ofissuance equals zero we would have:

EPS = 100 = $3.33.

50-20

It is not necesS8ty to issue as much debt as $400. A smaller amount

would accomplish the objective ofthe finn earning $2.10 per share.

The June 27, 2001 Wall Street Journal reported that Merrill Lynch

warned that the earnings for the second quarter would be between $.52 and

$.57 a share. The earnings forecasts had been for $.82. The firm's stock

price dropped from $66.45 to $58.91 (down $7.54 or 11.3%).

It is not uncommon to have a desirable acquisition of a finn vetoed

by management because the acquisition would dilute (reduce) a finn's EPS.

Consider the following situation (there are zero operating synergies):

Earnings (after tax)

Shares

EPS

Initial Price ofa Share

Parent Firm

$3,360

1,600

$2.10

$ 20

Target Firm

$400

200

$ 2

$ 50

Shares of Parent to be issued: 3 shares for each Target share (600

shares). This is a "nominal" .20 premium: 60 -1 = .20. The pro-forma EPS

50

are $1.71.

3,760 Pro-forma EPS = -- = $1.71

2,200

Assume the reduction in EPS from $2.10 to $1.71 as a result ofthe

merger is not acceptable.

Now assume that Target can be acquired for $10,000 cash

(consistent with the $50 price and 200 shares outstanding).

Parent acquires Target and issues $10,000 of.06 debt. The after tax

interest cost is 600(1-.35) =$390. The new total earnings net ofinterest are

3,760 -390 =$3,370. The new pro-forma EPS is:

EPS = 3,370 =$2.11

1,600

Now there is a very small amount ofearnings accretion.

Conclusions

This chapter has focused on the effect of debt issuance on EPS.

While theory focuses on value, management practices frequently pay

attention to the effect debt issuance has on EPS. EPS can be manipulated by

a strategy ofdebt issuance and share repurchase. The capital structure deci-

sion should not be based on EPS, but the effect on EPS is likely to be

considered by management.

The result ofthe analysis is that we conclude that a high PIE firm (a

low EPS fIrm) will tend to be more reluctant to issue debt in substitution

p

for stock knowing that the effect on EPS will not be favorable.