Presentation on theme: "Capital Structure Policy Capital Structure Policy (Ch16)"— Presentation transcript:
1 Capital Structure Policy Capital Structure Policy (Ch16) The Effect of Financial LeverageHomemade Leverage – Capital Structure IrrelevancyM&M Propositions I and IIImpact of TaxesBankruptcy CostsOptimal Capital StructureThe Pie1Capital 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/500,000B. 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$1000KEPS (No Debt)0.41.02.0EPS (D/E = 1)-0.23.0
5 Financial Leverage, EPS and EBIT 32.521.510.5– 0.5– 1D/E = 1D/E = 0Note: Gains and losses to shareholders are magnified through leverageEBIT ($ millions, no taxes)
6 What is the cross point? Set EPS in A and B equal, we have EBIT = $500,000So EPS = $_ __ /shareWhat is meant by this point?
7 2. Homemade LeverageThe use of personal borrowing (by shareholders) to change the overall amount of financial leverage to which the individual is exposedExampleEarning effect caused by the firm’s capital structure effect could be replicated by investors’ homemade leverageCapital structure is irrelevant of investors’ net earningFirms should not worry about their capital structureAre 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 sharesEPS of unlevered firm $0.40 $1.00 $2.00Earnings for 100 shares $40.00 $ $200.00less interest on $500 at 10% $50.00 $50.00 $50.00Net earnings -$10.00 $50.00 $150.00
9 Firm adopt proposed capital structure Investor buy 50 shares Example: Homemade Leverage and ROEFirm adopt proposed capital structure Investor buy 50 sharesEPS of levered firm -$0.20 $1.00 $3.00Earnings for 50 shares -$10 $100 $150
10 3. Milestone in Finance: The M&M Propositions Financial leverage and firm value: Proposition ISince 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 TaxesThe interest tax shield and firm valueFor simplicity: (1) perpetual cash flows (2) no depreciation (3) no fixed asset or NWC spendingA firm is considering going from zero debt to $400 at 10%:Firm U Firm L (unlevered) (levered)EBIT $200 $200Interest 0 $40Tax (40%) $80 $64Net income $120 $96Cash 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 DVL = Vu + Tc*D – debt increases firm value, everything else equal
14 5. Bankruptcy and bankruptcy Cost Bankruptcy -- ownership transfer and limited liability ruleBankruptcy risk -- a probabilityDirect costs -- such as legal and administrative costsIndirect 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 ValueThe Static Theory of Capital StructureThe 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