1. Capital Structure Policy Capital Structure Policy (Ch16)
The Effect of Financial Leverage
Homemade Leverage – Capital Structure Irrelevancy
M&M Propositions I and II
Impact of Taxes
Bankruptcy Costs
Optimal Capital Structure
The Pie 1
Capital Structure Policy (Ch16)

2. Capital Structure, Cost of Capital, and the Value of the Firm
Key issues:
What is the relationship between capital structure and firm value?
What is the optimal capital structure?

3. 1. Basics of Financial Leverage
Ignoring taxes, and assuming a firm needs 500,000 shares if it uses no debt financing:
A. With no debt:
EPS = EBIT/500,000
B. With $2,500,000 in debt at 10% -- view debt as an annuity, principal needn’t be paid back at maturity:
EPS = (EBIT - $______)/250,000

4. Relationship between EBIT and ESP under different capital structure
$200K
$500K
$1000K
EPS (No Debt)
0.4
1.0
2.0
EPS (D/E = 1)
-0.2
3.0

5. Financial Leverage, EPS and EBIT3
2.5 2
1.5 1
0.5
– 0.5
– 1
D/E = 1
D/E = 0
Note: Gains and losses to shareholders are magnified through leverage
EBIT ($ millions, no taxes)

6. What is the cross point? Set EPS in A and B equal, we have
EBIT = $500,000
So EPS = $_ __ /share
What is meant by this point?

7. 2. Homemade Leverage
The use of personal borrowing (by shareholders) to change the overall amount of financial leverage to which the individual is exposed
Example
Earning effect caused by the firm’s capital structure effect could be replicated by investors’ homemade leverage
Capital structure is irrelevant of investors’ net earning
Firms should not worry about their capital structure
Are you crazy, Tong, by saying this?

8. Example: Homemade Leverage and ROE
Firm does not adopt proposed capital structure Investor puts up $500 and borrows $500 to buy 100 shares
EPS of unlevered firm $0.40 $1.00 $2.00
Earnings for 100 shares $40.00 $ $200.00
less interest on $500 at 10% $50.00 $50.00 $50.00
Net earnings -$10.00 $50.00 $150.00

9. Firm adopt proposed capital structure Investor buy 50 shares
Example: Homemade Leverage and ROE
Firm adopt proposed capital structure Investor buy 50 shares
EPS of levered firm -$0.20 $1.00 $3.00
Earnings for 50 shares -$10 $100 $150

10. 3. Milestone in Finance: The M&M Propositions
Financial leverage and firm value: Proposition I
Since investors can costlessly replicate the financing decisions of the firm, in the absence of taxes and other unpleasantries, the value of the firm is unaffected by its capital structure.
Corollary #1: There is no “magic” in finance - you can’t get something for nothing.
Corollary #2: Capital restructurings don’t create value, in and of themselves.
Corollary #3: The firm’s overall cost of capital is unaffected by its capital structure.

11. The interest tax shield and firm value
4. Impact of Taxes
The interest tax shield and firm value
For simplicity: (1) perpetual cash flows (2) no depreciation (3) no fixed asset or NWC spending
A firm is considering going from zero debt to $400 at 10%:
Firm U Firm L (unlevered) (levered)
EBIT $200 $200
Interest 0 $40
Tax (40%) $80 $64
Net income $120 $96
Cash flow from assets $120 $____
Tax saving = $16 = ____  $40 = TC  RD  D

12. What’s the link between debt and firm value?
Since interest creates a tax deduction, borrowing creates a tax shield. Its value is added to the value of the firm.
MM Proposition I (with taxes)
PV(tax saving) = $16/____ = $____
= (TC  RD  D)/RD = TC D
VL = Vu + Tc*D – debt increases firm value, everything else equal

13. M&M Proposition I with Taxes (Figure 16.4)

14. 5. Bankruptcy and bankruptcy Cost
Bankruptcy -- ownership transfer and limited liability rule
Bankruptcy risk -- a probability
Direct costs -- such as legal and administrative costs
Indirect Cost -- the cost of avoiding a bankruptcy filing incurred by a financially distressed firm

15. 6. The Optimal Capital Structure and the Value of the Firm
Borrowing money is a good news/bad news proposition.
The good news: interest payments are deductible and create a “debt tax shield” (i.e., TCD).
The bad news: all else equal, borrowing more money increases the probability (and, therefore, the expected value) of direct and indirect bankruptcy costs.
Key issue: The Impact of Financial Distress on Firm Value
The Static Theory of Capital Structure
The theory that a firm borrows up to the point where the tax benefit from an extra dollar of debt is exactly equal to the cost that comes from the increased probability of financial distress.

16. The Optimal Capital Structure and the Value of the Firm

17. The Pie Model

18. What should we know about finance in the future
Option and other financial derivatives
Firms’ dividend policy
… you name them …