Presentation on theme: "Capital Structure Policy (ch 16) The Effect of Financial Leverage Homemade Leverage – Capital Structure Irrelevancy M&M Propositions I and II Impact of."— Presentation transcript:
Capital Structure Policy (ch 16) 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 Capital Structure Policy (Ch16)
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?
Capital Structure Policy (Ch 16) 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
Capital Structure Policy (Ch 16) EBIT$200K$500K$1000K EPS (No Debt)0.41.02.0 EPS (D/E = 1)-0.21.03.0 Relationship between EBIT and ESP under different capital structure
Capital Structure Policy (Ch 16) Financial Leverage, EPS and EBIT EBIT ($ millions, no taxes) EPS ($) 0 0.2 0.4 0.6 0.8 1 3 2.5 2 1.5 1 0.5 0 – 0.5 – 1 D/E = 1 D/E = 0 Note: Gains and losses to shareholders are magnified through leverage
Capital Structure Policy (Ch 16) 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?
Capital Structure Policy (Ch 16) 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?
Capital Structure Policy (Ch 16) 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$100.00$200.00 less interest on $500 at 10%$50.00$50.00$50.00 Net earnings-$10.00$50.00$150.00
Capital Structure Policy (Ch 16) 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
Capital Structure Policy (Ch 16) 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.
Capital Structure Policy (Ch 16) 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 UFirm L (unlevered)(levered) EBIT$200$200 Interest0$40 Tax (40%)$80$64 Net income$120$96 Cash flow from assets$120$____ Tax saving = $16 = ____ $40 = T C R D D
Capital Structure Policy (Ch 16) 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/____ = $____ = (T C R D D)/R D = T C D V L = V u + T c *D – debt increases firm value, everything else equal
Capital Structure Policy (Ch 16) M&M Proposition I with Taxes (Figure 16.4)
Capital Structure Policy (Ch 16) 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
Capital Structure Policy (Ch 16) Borrowing money is a good news/bad news proposition. The good news: interest payments are deductible and create a “debt tax shield” (i.e., T C D). 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. 6. The Optimal Capital Structure and the Value of the Firm
Capital Structure Policy (Ch 16) The Optimal Capital Structure and the Value of the Firm
Capital Structure Policy (Ch 16) The Pie Model
Capital Structure Policy (Ch 16) What should we know about finance in the future Option and other financial derivatives Firms’ dividend policy … you name them …