Presentation on theme: "Financial Leverage and Capital Structure Policy"— Presentation transcript:
1 Financial Leverage and Capital Structure Policy Chapter 16
2 Capital Restructuring What is meant by capital restructuringWhat is the primary goal of financial managers?Can leverage help in achieving such goals?
3 Capital Restructuring We are going to look at how changes in capital structure affect the value of the firm, all else equalCapital restructuring involves changing the amount of leverage a firm has without changing the firm’s assetsThe firm can increase leverage by issuing debt and repurchasing outstanding sharesThe firm can decrease leverage by issuing new shares and retiring outstanding debt
4 Choosing a Capital Structure What is the primary goal of financial managers?Maximize stockholder wealthWe want to choose the capital structure that will maximize stockholder wealthWe can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC
5 Financial Leverage The extent to which a firm relies on debt The more debt financing a firm uses in its capital structure, the more financial leverage it employs
6 Financial leverage, EPS, and ROE: an example proposedcurrent8,000,000Asset4,000,000debtEquity1Debt-equity ratio20Share price200,000400,000Shares out standing10%Interest rate
7 Financial leverage, EPS, and ROE: an example Current capital structure : No DebtexpansionexpectedRecession1,500,0001,000,000500,000EBITInterestNet income18.75%12.5%6.25%ROE3.752.51.25EPSProposed capital structure : debt= 4$ million400,0001,100,000600,000100,00027.5%15%2.5%5.530.5$
8 Break-Even EBITFind EBIT where EPS is the same under both the current and proposed capital structuresIf we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholdersIf we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders
9 Ex 1 Page 540Maynard, Inc., has no debt outstanding and a total market value of 250,000$. EBIT are projected to be 28,000$ if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 50 percent lower. Maynard is considering a 90,000$ debt issue with a 7 percent interest rate. The proceeds will be used to repurchase a share of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problemCalculate 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.Repeat part (a) assuming that the economy goes with recapitalization. What do you observe?
10 Ex 4 Page 542James Corporation is comparing two different capital structures: an all equity plan (plan I) and a levered plan (plan II). Under plan I, the company would have 160,000 shares of stock outstanding. Under plan II, there would be 80,000 shares of stock outstanding and 2.8$ million in debt outstanding. The interest rate on the debt is 8 percent and there are no taxes.If EBIT is 350,000$, which plan will result in the higher EPS?If EBIT is 500,000$, which plan will result in the higher EPS?What is the break-even EBIT?
11 Corporate borrowing & home made leverage The effect of leverage depends on the company’s EBIT. When EBIT is relatively high, leverage is beneficialUnder the expected scenarios, leverage increase the returns to shareholders, as measured by both ROE and EPSShareholders are exposed to more risk under the proposed capital structure because the EPS and ROE are much more sensitive to changes in EBIT in this caseBecause of the impact that financial leverage has on both the expected return to stockholder and the riskiness of the stock, capital structure is an important consideration
12 Corporate borrowing & home made leverage Homemade leverage: the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.
13 Corporate borrowing & home made leverage Proposed capital structureexpansionexpectedrecession5.5$3$0.5$EPS55030050Earnings for 100 sharesOriginal capital structure and homemade leverage3.752.51.25750500250Earnings for 200 shares200Less: interest on $2,000 at 10%Net earnings
14 Ex 9 Page 543ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with 600,000$ in stock. XYZ uses both stock and perpetual debt; its stock is worth 300,000$ and the interest rate on its debt is 8 percent. Both firms expect EBIT to be 80,000$Rico owns 30,000$ worth of XYZ’s stock. What rate of return is he expecting?Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage?
15 Capital Structure Theory Modigliani and Miller (M&M)Theory of Capital StructureProposition I: the value of the firm is independent of the firm’s capital structureThe value of the firm is NOT affected by changes in the capital structureThe cash flows of the firm do not change; therefore, value doesn’t change (THE PIE MODEL)
16 Capital Structure Theory Proposition IIThe firm’s cost of equity capital is a positive linear function of the firm’s capital structureRE = RA + (RA – RD)(D/E)The cost of equity depends on three thingsThe WACC of the firm is NOT affected by capital structure
18 Example What is the cost of equity? Required return on assets = 16%; cost of debt = 10%; 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?
19 M & M proposition I and II with corporate taxes Interest is tax deductibleTherefore, when a firm adds debt, it reduces taxes, all else equalThe reduction in taxes increases the cash flow of the firmHow should an increase in cash flows affect the value of the firm?
20 M & M proposition I and II with corporate taxes Firm LFirm U1,000EBIT80I920Taxable income276300Taxes (30%)644700NI
21 M & M proposition I and II with corporate taxes Firm LFirm UCFFA1,oooEBIT276300Taxes724700totalFirm LFirm UCash flow644700To stock holder80To bond holder724total
23 M & M proposition I and II with corporate taxes Interest tax shield: the tax saving attained by a firm from interest expenseProposition I with taxes:Value of a levered firm = value of an unlevered firm + PV of interest tax shieldVL = VU + DTC
24 ExampleEBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%Calculate the PV of VU, VL?
26 Ex 10 Page 543Wood Crop. Uses no debt. The WACC is 9 percent. If the current market value of the equity is 23$ million and there are no taxes, what is EBIT?
27 Ex 11 Page 543In the previous question suppose that corporate tax rate is 35 percent. What is EBIT? What is the WACC? Explain?
28 Ex 14 Page 543Frederick & Co. expects its EBIT to be 92,000$ every year for ever. The firm can borrow at 9 percent. Frederick currently has no debt, and its cost of equity is 15 percent. If the tax rate is 35 percent, what is the value of the firm? What will the value be if the company borrows 60,000$ and uses the proceeds to repurchase shares?
29 Ex 15 Page 544In problem 14, what is the cost of equity after recapitalization? What is the WACC? What are the implications for the firm’s capital structure decision?
30 Bankruptcy Costs Direct costs Financial distress Legal and administrative costsUltimately cause bondholders to incur additional lossesDisincentive to debt financingFinancial distressSignificant problems in meeting debt obligationsFirms that experience financial distress do not necessarily file for bankruptcy
31 Bankruptcy Costs Indirect bankruptcy costs Larger than direct costs, but more difficult to measure and estimateStockholders want to avoid a formal bankruptcy filingBondholders want to keep existing assets intact so they can at least receive that moneyAssets lose value as management spends time worrying about avoiding bankruptcy instead of running the businessThe firm may also lose sales, experience interrupted operations and lose valuable employees
32 Optimal Capital Structure The static theory of capital structure:
33 Optimal Capital Structure and the cost of capital
35 Conclusions Case I – no taxes or bankruptcy costs No optimal capital structureCase II – corporate taxes but no bankruptcy costsOptimal capital structure is almost 100% debtEach additional dollar of debt increases the cash flow of the firmCase III – corporate taxes and bankruptcy costsOptimal capital structure is part debt and part equityOccurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs