1. 19-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Nineteen Financial Leverage and Capital Structure Policy

2. 19-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 19.1The Capital Structure Question 19.2 The Effect of Financial Leverage 19.3 Capital Structure and the Cost of Equity Capital 19.4 M&M Propositions I & II With Corporate Taxes 19.5 Bankruptcy Costs 19.6 Optimal Capital Structure 19.7 The Pie Again 19.8 Imputation and M&M 19.9 Observed Capital Structures Summary and Conclusions Chapter Organisation

3. 19-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Understand the impact of financial leverage on a firm’s capital structure. Illustrate the concept of home-made leverage. Outline both M&M Proposition I and M&M Proposition II. Discuss the impact of corporate taxes on M&M Propositions I and II. Understand the impact of bankruptcy costs on the value of a firm. Identify a firm’s optimal capital structure.

4. 19-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Capital Structure Question Key issues –What is the relationship between capital structure and firm value? –What is the optimal capital structure? Capital structure and the cost of capital –The optimal capital structure is chosen if WACC is minimised.

5. 19-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Effect of Financial Leverage Financial leverage refers to 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. Financial leverage can dramatically alter the payoffs to shareholders in the firm. However, financial leverage may not affect the overall cost of capital.

6. 19-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Computing Break- even EBIT ABC Company currently has no debt in its capital structure. The company has decided to restructure, raising $2.5 million debt at 10 per cent. ABC currently has 500 000 shares on issue at a price of $10 per share. As a result of the restructure, what is the minimum level of EBIT the company needs to maintain EPS (the break-even EBIT)? Ignore taxes.

7. 19-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Computing Break- even EBIT (continued) With no debt: EPS = EBIT/500 000 With $2.5 million in debt @ 10%: EPS = (EBIT – $250 000 1 )/250 000 2 1 Interest expense = $2.5 million × 10% = $250 000 2 Debt raised will refund 250 000 ($2.5 million/$10) shares, leaving 250 000 shares outstanding

8. 19-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Computing Break- even EBIT (continued) These are then equal: EPS = EBIT/500 000 = (EBIT – $250 000)/250 000 With a little algebra: EBIT = $500 000  EPS BE = $1.00 per share

9. 19-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Computing Break- even EBIT (continued) 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 (with debt) D/E = 0 (no debt) Break-even point

10. 19-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Effect of Financial Leverage The effect of financial leverage depends on the company’s EBIT. The break-even EBIT is where a firm makes a return just sufficient to pay the interest on debt. If EBIT is above the break-even point, leverage is beneficial. If EBIT is below the break-even point, leverage is not beneficial. With financial leverage, shareholders are exposed to more risk because EPS and ROE are more sensitive to changes in EBIT.

11. 19-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Corporate Borrowing and Home- made Leverage Despite the effects of financial leverage it does not necessarily follow that capital structure is an important consideration. Why? Because shareholders can adjust the amount of financial leverage by borrowing and lending on their own. Home-made leverage is the use of personal borrowing to alter the degree of financial leverage to which an individual is exposed.

12. 19-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Home-made Leverage and ROE Original capital structure and home-made leverage  investor uses $500 of their own and borrows $500 to purchase 100 shares. Proposed capital structure  investor uses $500 of their own, together with $250 in shares and $250 in bonds.

13. 19-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Original Capital Structure and Home-made Leverage

14. 19-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Proposed Capital Structure

15. 19-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Capital Structure Theory Modigliani and Miller (M&M) Theory of Capital Structure: –Proposition I—firm value –Proposition II—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

16. 19-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan M&M Proposition I The size of the pie does not depend on how it is sliced. The value of the firm is independent of its capital structure. Value of firm

17. 19-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan M&M Proposition II Because of Proposition I, the WACC must be constant, with no taxes: WACC = R A = (E/V) × R E + (D/V) × R D where R A is the required return on the firm’s assets Solve for R E to get M&M Proposition II: R E = R A + (R A – R D ) × (D/E)

18. 19-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Cost of Equity and the WACC Debt-equity ratio, D/E Cost of capital WACC = R A RDRD R E = R A + (R A – R D ) x (D/E) The firm’s overall cost of capital is unaffected by its capital structure.

19. 19-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Business and Financial Risk By M&M Proposition II, the required rate of return on equity arises from sources of firm risk. Proposition II is: R E = R A + [R A – R D ] × [D/E] Business risk—equity risk arising from the nature of the firm’s operating activities (measured by R A ). Financial risk—equity risk that comes from the financial policy (i.e. capital structure) of the firm (measured by [R A – R D ] × [D/E]).

20. 19-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The SML and M&M Proposition II How do financing decisions affect firm risk in both M&M’s Proposition II and the CAPM? Consider Proposition II: All else equal, a higher debt/equity ratio will increase the required return on equity, R E. R E = R A + (R A – R D ) × (D/E)

21. 19-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The SML and M&M Proposition II (continued) Substitute R A = R f + (R M  R f )β A and by replacement R E = R f + (R M  R f )β E The effect of financing decisions is reflected in the equity beta, and, by the CAPM, increases the required return on equity. β E = β A (1 + D/E) Debt increases systematic risk (and moves the firm along the SML).

22. 19-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Corporate Taxes The interest tax shield is the tax saving attained by a firm from interest expense. Assumptions: –perpetual cash flows –no depreciation –no fixed asset or NWC spending. For example, a firm is considering going from $0 debt to $400 debt at 10 per cent.

23. 19-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Corporate Taxes (continued) Tax saving = $16 = 0.40 x $40 = T C × R D × D

24. 19-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Corporate Taxes (continued) What is the link between debt and firm value? –Since interest creates a tax deduction, borrowing creates a tax shield. The value added to the firm is the present value of the annual interest tax shield in perpetuity. M&M Proposition I (with taxes): Key result: V L = V U + T C D

25. 19-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Total debt (D) Value of the firm (V L ) VUVU V L = V U + T C x D = T C VUVU T C x D V L = V U + $160 VUVU $400 M&M Proposition I with Taxes

26. 19-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Taxes, WACC and Proposition II Taxes and firm value: an example –EBIT = $100 –T C = 30% –R U = 12.5% Suppose debt goes from $0 to $100 at 10 per cent. What happens to equity value, E? V U = $100 × (1 – 0.30)/0.125 = $560 V L = $560 + (0.30 × $100) = $590  E = $490

27. 19-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Taxes, WACC and Proposition II WACC and the cost of equity (M&M Proposition II with taxes): R E = R U + (R U – R D ) × (D/E) × (1 – T C )

28. 19-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Debt-equity ratio, D/E Cost of capital (%) RURU R D  (1 – T C ) RERE WACC RERE RURU R D  (1 – T C ) Taxes, WACC and Proposition II

29. 19-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Taxes, WACC and Propositions I and II—Conclusions The no-tax case: –Implications of proposition I:  A firm’s capital structure is irrelevant  A firm’s WACC is the same no matter what the mixture of debt and equity is used to finance the firm. –Implications of proposition II:  The cost of equity rises as the firm increases its use of debt financing  The risk of the equity depends on two things: the riskiness of the firm’s operations (business risk) and the degree of financial leverage (financial risk).

30. 19-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Taxes, WACC, and Propositions I and II—Conclusions With taxes: –Implications of proposition I:  Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is 100 per cent debt.  A firm’s WACC decreases as the firm relies on debt financing. –Implications of proposition II:  Unlike proposition I, the general implications of proposition II are the same whether there are taxes or not.

31. 19-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Bankruptcy Costs Borrowing money is a good news/bad news proposition: –The good news: interest payments are deductible and create a debt tax shield (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.

32. 19-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Direct versus Indirect Bankruptcy Costs Direct bankruptcy costs are costs directly associated with bankruptcy such as legal and administrative expenses. Indirect bankruptcy costs are costs associated with spending resources to avoid bankruptcy. Financial distress: –significant problems in meeting debt obligations –most firms that experience financial distress do recover.

33. 19-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Optimal Capital Structure The static theory of capital structure: –A firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. This is the point at which WACC is minimised and the value of the firm is maximised. –It is called the static theory because it assumes that the firm is fixed in terms of its assets and operations and it only considers possible changes in the debt/equity ratio.

34. 19-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Value of the firm (V L ) Debt-equity ratio, D/E Optimal amount of debtD/E Present value of tax shield on debt Financial distress costs Actual firm value V U = Value of firm with no debt V L = V U + T C  D Maximum firm value V L * VUVU The Optimal Capital Structure and the Value of the Firm

35. 19-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cost of capital (%) Debt/equity ratio (D/E) D*/E* The optimal debt/equity ratio RURU WACC R D  (1 – T C ) RERE RURU WACC* Minimum cost of capital The Optimal Capital Structure and the Cost of Capital

36. 19-36 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Value of the firm ( V L ) Total debt (D) D* PV of bankruptcy costs Case III Static Theory Case I M&M (no taxes) VL*VL* VUVU Case II M&M (with taxes) Net gain from leverage The Capital Structure Question

37. 19-37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Managerial Recommendations Taxes –The tax benefit is only important if to firms in a tax-paying position. –The higher the tax payable, the greater the incentive to borrow. Financial distress: –The greater the risk of financial distress, the less debt will be optimal for the firm. –All other things equal, the greater the volatility in EBIT, the less a firm should borrow. –The costs of financial distress depend primarily on the firm’s assets and how easily ownership to those assets can be transferred.

38. 19-38 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Extended Pie Model

39. 19-39 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Corporate Borrowing and Personal Borrowing Without tax, corporate and personal borrowing are interchangeable. With corporate and personal tax, there is an advantage to corporate borrowing because of the interest tax shield. With corporate and personal tax, and dividend imputation, shareholders are again indifferent between corporate and personal borrowing.

40. 19-40 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Dynamic Capital Structure Theories Pecking order theory: –Investment is financed first with internal funds, then debt, and finally with equity. Information asymmetry cost: –Management has superior information on the prospects of the firm. Agency costs of debt: –These occur when equity holders act in their own best interests rather than the interests of the firm.

41. 19-41 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Debt-to-Equity Ratios for Selected Australian Industries, 2006 IndustryDebt/Equity % Banks129 Coal10 Engineering31 Gas141 Gold15 Medical11 Oil8 Property trusts69 Real Estate40 Retail28 Telecommunications17

42. 19-42 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions The optimal capital structure for a firm is one that maximises the value of the firm and minimises the overall cost of capital. If taxes, financial distress costs, and any other imperfections are ignored, the firm’s capital structure is simply irrelevant. If company taxes are considered, capital structure matters a great deal. Bankruptcy or financial distress costs reduce the attractiveness of debt financing. Australian firms typically do not use great amounts of debt (but pay substantial taxes) and firms in similar industries tend to have similar capital structures.