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**Chapter 16 Financial Leverage and Capital Structure Policy**

T Chapter Outline Chapter 16 Financial Leverage and Capital Structure Policy Chapter Organization 16.1 The Capital Structure Question 16.2 The Effect of Financial Leverage 16.3 Capital Structure and the Cost of Equity Capital 16.4 M&M Propositions I and II with Corporate Taxes 16.5 Bankruptcy Costs 16.6 Optimal Capital Structure 16.7 The Pie Again 16.8 Observed Capital Structures 16.9 Long-term Financing under Financial Distress and Bankruptcy 16.10 Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE copyright © 2002 McGraw-Hill Ryerson, Ltd.

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**T16.2 Capital Structure, Cost of Capital, and the Value of the Firm**

Key issues: What is the relationship between capital structure and firm value? Measuring Capital Structure - Leverage and the Debt/Equity ratio What is the optimal capital structure? Preliminaries: Capital restructurings Optimal capital structure: firm value vs. stock value Optimal capital structure: firm value vs. WACC

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**T16.3 Example: Computing Break-Even EBIT**

Ignoring taxes: A. With no debt: EPS = EBIT/500,000 B. With $2,500,000 in debt at 10%: EPS = (EBIT - $______)/250,000 C. These are equal when: EPSBE = EBITBE/______ = (EBITBE - $250,000)/250,000 D. With a little algebra: EBITBE = $500,000 So EPSBE = $___ /share

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**T16.3 Example: Computing Break-Even EBIT**

Ignoring taxes: A. With no debt: EPS = EBIT/500,000 B. With $2,500,000 in debt at 10%: EPS = (EBIT - $250,000)/250,000 C. These are equal when: EPSBE = EBITBE/500,000 = (EBITBE - $250,000)/250,000 D. With a little algebra: EBITBE = $500,000 So EPSBE = $1.00/share

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**T16.4 Financial Leverage, EPS and EBIT**

3 2.5 2 1.5 1 0.5 – 0.5 – 1 D/E = 1 D/E = 0 EBIT ($ millions, no taxes)

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**T16.5 Degree of Financial Leverage**

The Degree of Financial Leverage is measured as Percentage Change in EPS Percentage Change in EBIT A convenient alternative calculation is

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**T16.6 EPS Versus EBIT (with and without debt)**

5 With Debt 4 3 No Debt 2 Advantage to debt 1 EPS EBIT - 400,000 800,000 1,200,000 1,600,000 -1 Disadvantage to debt -2 -3

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**T16.7 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 $0.60 $1.30 $1.60 Earnings for 100 shares $60.00 $ $160.00 less interest on $500 at 10% $50.00 $50.00 $50.00 Net earnings $10.00 $80.00 $110.00 ROE 2% 16% 22%

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**T16.7 Homemade Leverage: An Example (concluded)**

Firm adopts proposed capital structure Investor puts up $500, $250 in stock and $250 in bonds EPS of levered firm $0.20 $1.60 $2.20 Earnings for 25 shares $5.00 $40.00 $55.00 plus interest on $250 at 10% $25.00 $25.00 $25.00 Net earnings $30.00 $65.00 $80.00 ROE 6% 13% 16%

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**T16.8 Milestones in Finance: The M&M Propositions**

Financial leverage and firm value: Proposition I Since investors can costlessly replicate the financing decisions of the firm (remember “homemade leverage”?), 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. (Why is the last part of the statement so important? Stay tuned.)

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**T16.8 Milestones in Finance: The M&M Propositions (concluded)**

The cost of equity and financial leverage: Proposition II A. Because of Prop. I, the WACC must be constant. With no taxes, WACC = RA = (E/V) RE + (D/V) RD where RA is the required return on the firm’s assets B. Solve for RE to get MM Prop. II RE = RA + (RA - RD) (D/E) ( ) Cost of equity has two parts: 1. RA and “business” risk 2. D/E and “financial” risk

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**T16.9 The Cost of Equity and the WACC (See Figure 16.3)**

Cost of capital RE = RA + (RA – RD ) x (D/E) WACC = RA RD Debt-equity ratio, D/E

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**T16.10 The CAPM, the SML, and Proposition II**

The effect of financing decisions on firm risk is reflected in both M&M’s Proposition II and in the CAPM. Consider Proposition II: All else equal, a higher debt-equity ratio will increase the required return on equity, RE. M&M Proposition II: RE = RA + (RA - RD) (D/E) The effect of financing decisions is reflected in the equity beta, and, by the CAPM, increases the required return on equity. CAPM: RE = RF + (RM - RF) E In other words, debt increases systematic risk (and moves the firm along the SML).

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**T16.11 Business Risk and Financial Risk**

By M&M Proposition II, the required return on equity arises from two sources of firm risk. Proposition II is: RE = RA + (RA - RD) (D/E) Business risk - equity risk that comes from the nature of the firm’s operating activities (measured by RA in the equation above); and Financial risk - equity risk that comes from the financial policy (i.e., capital structure) of the firm. Financial risk is measured by (RA - RD) (D/E) in the equation above.

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**T16.12 Debt, Taxes, Bankruptcy, and Firm Value**

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

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**T16.12 Debt, Taxes, Bankruptcy, and Firm Value**

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 $136 Tax saving = $16 = $40 = TC RD D

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**T16.12 Debt, Taxes, Bankruptcy, and Firm Value (concluded)**

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

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**T16.12 Debt, Taxes, Bankruptcy, and Firm Value (concluded)**

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/.10 = $160 = (TC RD D)/RD = TC D Key result: VL = VU + TC D

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**T16.13 M&M Proposition I with Taxes (Figure 16.4)**

VL=VU+TCXD =TC TD X D

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**T16.14 Example: Debt, Taxes, and the WACC**

Taxes and firm value: an example EBIT = $100 TC = 30% RU = 12.5% Q. Suppose debt goes from $0 to $100 at 10%, what happens to equity value, E? VU = $100 (______)/.125 = $560 VL = $ $_____ = $590, so E = $_____ .

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**T16.14 Example: Debt, Taxes, and the WACC**

Taxes and firm value: an example EBIT = $100 TC = 30% RU = 12.5% Q. Suppose debt goes from $0 to $100 at 10%, what happens to equity value, E? VU = $100 ( )/.125 = $560 VL = $ $100 = $590, so E = $490 .

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**T16.14 Example: Debt, Taxes, and the WACC (concluded)**

WACC and the cost of equity (MM Proposition II with taxes) With taxes: RE = RU + (RU - RD) (D/E) (1 - TC ) RE = _____+ (_____- .10) ($____/____) ( ) = % WACC = ($____/____) (100/590) .10 ( ) = %

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**T16.14 Example: Debt, Taxes, and the WACC (concluded)**

WACC and the cost of equity (MM Proposition II with taxes) With taxes: RE = RU + (RU - RD) (D/E) (1 - TC ) RE = ( ) ($100/490) ( ) = % WACC = ($490/590) (100/590) .10 ( ) = % Notice: The WACC decreases as more debt financing is used. Optimal capital structure is all debt!

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**T16.15 Taxes, the WACC, and Proposition II**

Cost of capital (%) RE RU WACC RD (1 – TC) Debt-equity ratio, D/E

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**T16. 15 The Cost of Equity and the WACC: M&M Proposition II with Taxes**

T The Cost of Equity and the WACC: M&M Proposition II with Taxes (Figure 16.5) Rdx(1-TC) =8%x(1-.30) =5.6% Rdx(1-TC) M&M Proposition I with taxes implies that a firm’s WACC decreases as the firm relies more heavily on debt financing. M&M Proposition II with taxes implies that the firm’s cost of equity rises as the firm relies more heavily on debt financing.

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**T16.16 Modigliani and Miller Summary (Table 16.6)**

I. The No-Tax Case A. Proposition I: The value of the firm levered equals the value of the firm unlevered: VL = VU Implications of Proposition I: 1. A firm’s capital structure is irrelevant. 2. A firm’s WACC is the same no matter what mix of debt and equity is used. B. Proposition II: The cost of equity, RE, is RE = RA + (RA - RD) D/E where RA is the WACC, RD is the cost of debt, and D/E is the debt/equity ratio. C. Implications of Proposition II 1. The cost of equity rises as the firm increases its use of debt financing. 2. The risk of equity depends on the risk of firm operations and on the degree of financial leverage.

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**T16.16 Modigliani and Miller Summary (Table 16.6) (concluded)**

II. The Tax Case A. Proposition I with Taxes: The value of the firm levered equals the value of the firm unlevered plus the present value of the interest tax shield: VL = VU + TcD where Tc is the corporate tax rate and D is the amount of debt. B. Implications of Proposition I: 1. Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is 100 percent debt. 2. A firm’s WACC decreases as the firm relies more heavily on debt financing.

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**T16.17 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.

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**T16.17 The Optimal Capital Structure and the Value of the Firm (continued) (Figure 16.6)**

VL=VU+TCXD

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**T16.18 The Optimal Capital Structure and the Cost of Capital (Figure 16.7)**

Rdx(1-TC)

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**T16.19 The Capital Structure Question (Figure 16.8)**

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T The Pie(Figure 16.8)

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T D/E ratios from table 16.7

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**T16.22 Long-term financing under financial distress**

Definitions of financial distress Business failure Legal bankruptcy Technical insolvency Accounting insolvency What happens Varies depending on the severity of the distress and the recourse that debt-holders have negotiated Liquidation versus Reorganization of assets Relaxing covenant restrictions when the firm is in financial distress.

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T Chapter 16 Quick Quiz 1. Why does the firm’s cost of equity increase with leverage? All else equal, as the D/E ratio increases, the riskiness of the remaining equity increases. 2. What are direct bankruptcy costs? Direct bankruptcy costs are generally observable and, therefore, measurable. Examples: legal fees, accounting fees, administrative expenses. 3. What kinds of firms would be most likely to suffer indirect bankruptcy costs? Firms most likely to lose customers and/or sales as the likelihood of distress increases. 4. Name three types of financial distress. Business failure; legal bankruptcy; technical insolvency

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T Solution to Problem 16.1 Probit, Inc. has no debt outstanding and a total market value of $80,000. Earnings before interest and taxes (EBIT) are projected to be $4,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30% higher. If there is a recession, then EBIT will be 60% lower. Probit is considering a $35,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,000 shares outstanding. Ignore taxes for this problem. a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession. b. Repeat part (a) assuming that Probit goes through with the recapitalization. What do you observe?

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**T16.24 Solution to Problem 16.1 (continued)**

a. EBIT: $1,600 $4,000 $_____ Interest: 0 0 0 Taxes: NI: $_____ $4,000 $_____ EPS: $ .80 $2.00 $____ EPS: -60% %

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**T16.24 Solution to Problem 16.1 (continued)**

a. EBIT: $1,600 $4,000 $5,200 Interest: 0 0 0 Taxes: NI: $1,600 $4,000 $5,200 EPS: $ .80 $2.00 $2.60 EPS: -60% %

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**T16.24 Solution to Problem 16.1 (concluded)**

b. $80,000/2,000 shares = $40 per share $35,000/$40 = 875 shares bought back 2, = 1,125 shares left outstanding EBIT: $1,600 $4,000 $5,200 Interest: 1,750 1,750 1,750 Taxes: NI: -$150 $2,250 $3,450 EPS: -$0.13 $2.00 $3.07 EPS: % %

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**According to M&M, V = VU + TCD.**

T Solution to Problem 16.11 Drednaught Corp. uses no debt. The weighted average cost of capital (WACC) is 12 percent. If the current market value of the equity is $25 million, and the corporate tax rate is 34 percent, what is the EBIT? What is the WACC? Explain. According to M&M, V = VU + TCD. In this case, V = $25M, WACC = 12%, and D = 0. So, V = $25M = EBIT( )/ EBIT = $4.545M

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**a. What is Fordebtful’s cost of equity capital? **

T Solution to Problem 16.12 Fordebtful Industries has a debt/equity ratio of 2.5. Its WACC is 12 percent, and its cost of debt is 12 percent. The corporate tax rate is 35 percent. a. What is Fordebtful’s cost of equity capital? b. What is Fordebtful’s unlevered cost of equity capital? c. What would the cost of equity be in part (a) if the debt/equity ratio were 1.5? What if it were 1.0? What if it were zero?

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**T16.26 Solution to Problem 16.12 (concluded)**

a. Since WACC = (E/V)(RE ) + (D/V)(RD)(1 - TC), WACC = .12 = (.2857)RE + (.7143)(.12)(.65), Solving, RE = .2250 b = RU + (RU )(2.5)(.65) Solving, RU = .16 c. .12 = (.40)RE + (.60)(.12)(.65) Solving, RE = .1830 .12 = (.50)RE + (.50)(.12)(.65) Solving, RE = .1620 .12 = (1.0)RE + (0)(.12)(.65) Solving, RE = RU = WACC = .12

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