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**Week 10 Lecture 10 Ross, Westerfield and Jordan 7e Chapter 17**

Financial Leverage and Capital Structure Policy

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**Last Lecture.. Cost of Equity Cost of Preferred Stock Cost of Debt**

Proportion or weight of each form of financing Cost of Capital = WACC Unadjusted/Adjusted When should we use WACC? Other approaches: pure play and subjective Flotation Costs

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**Chapter 17 Outline The Capital Structure Question**

The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure

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**Choosing a Capital Structure**

What is the primary goal of financial managers? Maximize stockholder wealth Choose the optimal capital structure Maximize the value of the firm Minimize the WACC

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**Capital Restructuring**

Financial leverage = the extent to which a firm relies on debt financing Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets The firm can increase leverage by issuing debt and repurchasing outstanding shares The firm can decrease leverage by issuing new shares and retiring outstanding debt

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The Effect of Leverage How does leverage affect the EPS and ROE of a firm? More debt financing, means more fixed interest expense In expansion, we have more income after we pay interest, have more left over for stockholders In recession, we still have to pay our costs therefore we have less left over for stockholders Leverage amplifies the variation in both EPS and ROE

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**Example: Financial Leverage, EPS and ROE**

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**Break-Even EBIT Break-Even EBIT where: EPS debt = EPS no debt**

If expected EBIT > break-even EBIT, then leverage is beneficial to our stockholders If expected EBIT < break-even EBIT, then leverage is detrimental to our stockholders

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**Example: Break-Even EBIT**

Numbers in thousands EPS with No Debt = $500/500 = $1 EPS with Debt = ($500-$250)/250 = $1

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Break Even EBIT With debt With no debt

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**Capital Structure Theory**

Modigliani and Miller Theory of Capital Structure Proposition I – firm value Proposition II – cost of equity & WACC The value of the firm is determined by the cash flows to the firm and the risk of the assets Changing firm value Change the risk of the cash flows Change the cash flows

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**Capital Structure Theory Under Three Special Cases**

Case I – Assumptions No taxes No bankruptcy costs Case II – Assumptions With taxes Case III – Assumptions With bankruptcy costs

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**Case I – No Taxes Proposition I Proposition II**

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 Cost of Equity increases as Debt increases The WACC of the firm is NOT affected by capital structure

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**Case I - No Taxes - Equations**

WACC = RA = (E/V)RE + (D/V)RD RE = RA + (RA – RD)(D/E) RA is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets (RA – RD)(D/E) is the “cost” of the firm’s financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage

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Figure 17.3

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**Case I - No Taxes - Example**

Data Required return on assets = WACC = RA = 16%, Cost of debt = RD = 10% Percent of debt = D = 45% E = = 0.55 or 55% D/E = 0.45/0.55 = 0.82 What is the cost of equity? RE = RA + (RA – RD)(D/E) RE = (0.16 – 0.10)(.45/.55) = 20.91% Proof for WACC: WACC = RA = (E/V)RE + (D/V)RD WACC = RA = 0.55 * 20.91% * 10% = 16%

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**Case I – No Taxes Example continued..**

What happens if the firm increases leverage so that D/E = 1.5? (before D/E = 0.82 when D=45%,E=55%) What is the cost of equity? RE = RA + (RA – RD)(D/E) RE = (0.16 – 0.10)(1.5) = 0.25 or 25% Proof for WACC: WACC = RA = (E/V)RE + (D/V)RD From D/E = 1.5, D = 60%, E = 40% WACC = 0.4 * 25% * 10% = 16%

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**The CAPM, Business Risk, Financial Risk and Proposition II**

How does financial leverage affect systematic risk? CAPM: RE = Rf + E(RM – Rf) – for equity CAPM: RA = Rf + A(RM – Rf) – for assets Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets, also called unleverred beta – the risk of the assets if the firm would have no debt ( in essence E = A if no debt) RE = RA + (RA – RD)(D/E) RE = RA + (RA – Rf)(D/E) - assume RD = Rf Proposition II As we introduce debt in the firm: RE = Rf + A(1+D/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)

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**Case II – Introducing Taxes**

What happens to the firm’s cash flows? Interest is tax deductible Therefore, when a firm adds debt, it reduces taxes, all else equal The reduction in taxes increases the cash flow of the firm How should an increase in cash flows affect the value of the firm?

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**Case II - with Taxes - Example**

Unlevered Firm No Debt Levered Firm With Debt EBIT 5000 Interest Taxable Income 4500 Taxes (34%) 1700 1530 Net Income 3300 2970 CFFA 3470

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**Interest Tax Shield Annual interest tax shield**

Tax rate times interest payment 6250 in 8% debt = 500 in interest expense Annual tax shield = 0.34(500) = 170 Present value of annual interest tax shield Assume perpetual debt for simplicity PV = 170 / 0.08 = 2125

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**Case II - with Taxes - 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 Assuming perpetual cash flows VU = EBIT(1-T) / RU with no debt RU = RA= RE and VU = E VL = VU + D*TC E = VL - D

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**Case II – with Taxes Proposition I - Example**

Data Inc. has earnings of 25 million per year every year. The firm has no debt and the cost of capital is 12%. If tax is 35% what is the value of the firm? EBIT = 25 million; Tax rate = TC= 35%; Unlevered cost of capital = RU= 12% = RA = RE VU = ? VU = EBIT(1-T) / RU VU = 25(1-0.35) / 0.12 = $ million VU = E

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**Case II – with Taxes Proposition I - Example (cont.)**

Data Inc. decides to issue bonds that have a market value of 75 million at a cost of 9%. What is the value of the firm? What will be the value of equity? D = $75 million, RD= 9%, VL = ?, E = ? VU = (calculated on previous slide) VL = VU + tax shield VL = VU + D*TC VL = (0.35) = $ million E = VL - D E = – 75 = $86.67 million

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**Figure 17.4 Case II - with Taxes Proposition I**

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**Case II – with Taxes - Proposition II**

Recap: In case I – Proposition II - no taxes: RE increases as Debt increases WACC is unchanged When taxes are introduced in Case II: RE = RU + (RU – RD)(D/E)(1-TC) WACC decreases as D/E increases because the cost of debt decreases RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)

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**Case II – with Taxes Proposition II - Example**

Data Inc. info from Case II proposition I: EBIT = 25 million; TC= 35%; D = $75 million; RD= 9%; Unlevered cost of capital = RU= 12% E = $86.67m; VL = $161.67m D/E = 75/86.67 = 0.87, E/V = 86.67/ = 0.54, D/V = 75/ = 0.46 RE = RU + (RU – RD)(D/E)(1-TC) RE = ( )(0.87)(1-0.35) = 13.69% RL = WACC = (E/V)RE + (D/V)(RD)(1-TC) RL = WACC = (0.54)(0.1369) + (0.46)(0.09)(1-.35) = 10.05%

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**Example: Case II – Proposition II**

Suppose Data Inc. changes its capital structure so that the debt-to-equity ratio becomes 1. Before: D/E = 0.87, E= 54%, D=46% Now: D/E = 1, E= 50%, D=50% What will happen to the cost of equity under the new capital structure? (previously 13.69%) RE = (0.12 – 0.09)(1)(1-0.35) = 13.95% What will happen to the weighted average cost of capital? (previously 10.05%) WACC = 0.5(0.1395) + 0.5(0.09)(1-0.35) = 9.9% What if D/E = 1.25?, RE = ?, WACC = ?

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**Figure 17.5 - Case II with Taxes Proposition II**

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**Case III – with Bankruptcy Costs**

Now we add bankruptcy costs As the D/E ratio increases, the probability of bankruptcy increases This increased probability will increase the expected bankruptcy costs At some point, the additional value of the interest tax shield will be offset by the increase in 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

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**Figure 17.6 – Case III with Bankruptcy costs**

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**Figure 17.7 Case III with Bankruptcy costs**

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**Bankruptcy Costs Direct costs Indirect costs Financial distress costs**

Legal and administrative costs Indirect costs Larger than direct costs & more difficult to measure and estimate Financial distress costs All costs associated with going bankrupt and/or avoiding bankruptcy

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**Conclusions Case I – no taxes or bankruptcy costs**

No optimal capital structure Case II – corporate taxes but no bankruptcy costs Optimal capital structure is almost 100% debt Each additional dollar of debt increases the cash flow of the firm Case III – corporate taxes and bankruptcy costs Optimal capital structure is part debt and part equity Occurs where the benefit from an additional dollar of debt just offsets the increase in expected bankruptcy costs

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Figure 17.8

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**Managerial Recommendations**

The tax benefit is only important if the firm has a large tax liability Risk of financial distress The greater the risk of financial distress, the less debt will be optimal for the firm The cost of financial distress varies across firms and industries and as a manager you need to understand the cost for your industry

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End Chapter 17

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