0. Financial leverage and capital structure policy
Chapter 16
Financial leverage and capital structure policy

1. Chapter Outline The Capital Structure Decision
The Effect of Financial Leverage
Capital Structure and the Cost of Equity
Miller&Modigliani Propositions
Bankruptcy Costs
Optimal Capital Structure
Extended Pie Model
Observed Capital Structures

2. Capital Restructuring
Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets
Increase leverage by issuing debt and repurchasing outstanding shares
Decrease leverage by issuing new shares and retiring outstanding debt
Financial leverage = the extent to which the firm relies on debt

3. Choosing a Capital Structure
What is the primary goal of financial managers?
Maximize stockholder wealth
Stockholders’ wealth can be maximized by maximizing firm value or minimizing WACC

4. The Effect of Leverage
How does leverage affect the EPS and ROE of a firm?
When we increase the amount of debt financing, we increase the fixed interest expense
If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders
If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders
Leverage amplifies the variation in both EPS and ROE

5. Financial Leverage, EPS and ROE, example (1)
Current capital structure: No debt
Recession
Expected
Expansion
EBIT
$500,000
$1,000,000
$1,500,000
Interest
Net income
500,000
1,000,000
1,500,000
ROE
6.25%
12.50%
18.75%
EPS
$1.25
$2.50
$3.75
Proposed capital structure: Debt = $ 4 mln
400,000
100,000
600,000
1,100,000
2.50%
15.00%
27.50%
$0.50
$3.00
$5.50

6. Financial Leverage, EPS and ROE, example (2)
Variability in ROE
Current: ROE ranges from 6.25% to 18.75%
Proposed: ROE ranges from 2.50% to 27.50%
Variability in EPS
Current: EPS ranges from $1.25 to $3.75
Proposed: EPS ranges from $0.50 to $5.50
The variability in both ROE and EPS increases when financial leverage is increased

7. Degree of financial leverage

8. Break-Even EBIT
Find EBIT where EPS is the same under both the current and proposed capital structures
If EBIT is expected to be greater than the break-even point, then leverage is beneficial to stockholders
If EBIT is expected to be less than the break-even point, then leverage is detrimental to stockholders

9. Financial Leverage, EPS and ROE Breakeven (indifference) EBIT solution:

10. Homemade Leverage and ROE
Current Capital Structure
Investor borrows $2000 and uses $2000 of their own to buy 200 shares of stock
Payoffs:
Recession: 200(1.25) - .1(2000) = $50
Expected: 200(2.50) - .1(2000) = $300
Expansion: 200(3.75) - .1(2000) = $550
Mirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structure
Proposed Capital Structure
Investor buys $2000 worth of stock (100 shares)
Payoffs:
Recession: 100(0.50) = $50
Expected: 100(3.00) = $300
Expansion: 100(5.50)= $550
We are still ignoring taxes and transaction costs. If we factor in these market imperfections, then homemade leverage will not work quite as easily, but the general idea is the same.

11. Homemade leverage
The use of personal borrowing to change the overall amount of financial leverage to which individual is exposed
The investor can both “lever” his position through borrowing or “unlever” - through lending

12. Capital Structure Theory
Modigliani and Miller Theory of Capital Structure
Proposition I – the pie model
Proposition II – WACC
The value of the firm is determined by the cash flows to the firm and the risk of the assets

13. Capital Structure Theory Under Three Special Cases
Case I – Assumptions (M&M)
No corporate or personal taxes
No bankruptcy costs
Case II – Assumptions (M&M)
Corporate taxes
Case III – Assumptions (Static Theory)
Bankruptcy costs

14. Case I – No Taxes or Bankruptcy Costs
M&M Proposition I
The value of the firm is NOT affected by changes in the capital structure
The cash flows of the firm do not change, therefore value doesn’t change
Proposition II
The WACC of the firm is NOT affected by capital structure

15. Case I WACC = RA = (E/V)RE + (D/V)RD RE = RA + (RA – RD)(D/E)
RA is the required return on the firm’s assets
(RA – RD)(D/E) is the additional return required by stockholders to compensate for the risk of leverage

16. Case I, example Data What is the cost of equity?
Required return on assets = 16%, cost of debt = 10%; percent of debt = 45%
What is the cost of equity?
Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio?
Based on this information, what is the percent of equity in the firm?

17. The CAPM, the SML and Proposition II
CAPM: RA = Rf + A(RM – Rf)
Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets
Proposition II
RE = Rf + A(RM – Rf)(1+D/E)

18. Business Risk and Financial Risk
CAPM: RE = Rf + E(RM – Rf)
E = A(1 + D/E)
Therefore, the systematic risk of the stock depends on:
Systematic risk of the assets, A, (Business risk)
Level of leverage, D/E, (Financial risk)
RE = Rf + A(1+D/E)(RM – Rf)

19. Case II – With Corporate Taxes
Interest is tax deductible
The reduction in taxes increases the cash flow of the firm
Interest tax shield = The tax saving attained by a firm from interest expense

20. Case II, example (1) Unlevered Firm Levered Firm EBIT 5000 Interest
500
Taxable Income
4500
Taxes
1700
1530
Net Income
3300
2970
CFFA
3470

21. Case II, example (2)
Assume the company has $6,250, 8% coupon debt and faces a 34% tax rate.
Annual interest tax shield
Tax rate times interest payment:
Annual tax shield =
Present value of annual interest tax shield:

22. Case II – Proposition I
The value of the firm increases by the present value of the annual interest tax shield
Value of a levered firm = value of an unlevered firm + PV of interest tax shield
Value of equity = Value of the firm – Value of debt
VU = EBIT(1-T) / RU
VL = VU + DTC

23. Case II – Proposition I, example
EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% VU VL E

24. Case II – Proposition II
The WACC decreases as D/E increases because of the government subsidy on interest payments
WACC = (E/V)RE + (D/V)(RD)(1-TC)
RE = RU + (RU – RD)(D/E)(1-TC)
Example
RE = ( )(75/86.67)(1-.35) = 13.69%
WACC = (86.67/161.67)(.1369) + (75/161.67)(.09) (1-.35) WACC = 10.05%

25. Case II – Proposition II, example
Suppose that the firm changes its capital structure so that the D/E ratio = 1.
What will happen to the cost of equity under the new capital structure?
What will happen to the weighted average cost of capital?

26. Case III – with Bankruptcy Costs
As the D/E ratio increases, the probability of bankruptcy increases
At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy cost
At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added

27. Bankruptcy Costs (Financial distress costs)
Direct costs
Legal and administrative costs
Ultimately cause bondholders to incur additional losses
Disincentive to debt financing
Indirect costs
The difficulties of running business that is experiencing financial distress
Examples: potentially fruitful programs are dropped, employees are leaving the company

28. Static Theory of Capital Structure
A firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress
At this point the firm’s WACC is minimized

29. Static Theory and Firm Value

30. Extended Pie Model

31. The Value of the Firm
Value of the firm = marketed claims + non-marketed claims
Marketed - claims of stockholders and bondholders
Non-marketed - claims of the government and other potential stakeholders
The overall value of the firm is unaffected by changes in capital structure
The division of value between marketed claims and non-marketed claims may be impacted by capital structure decisions

32. Observed Capital Structures
Capital structure differ by industry
There is a connection between different industry’s operating characteristics and capital structure
Firms and lenders look at the industry’s debt/equity ratio as a guide