1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-1 Chapter Twenty Financial Leverage and Capital Structure Policy

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-2 20.1 The Capital Structure Question 20.2 The Effect of Financial Leverage 20.3 Capital Structure and the Cost of Equity Capital 20.4 M&M Propositions I & II With Corporate Taxes 20.5 Bankruptcy Costs 20.6 Optimal Capital Structure 20.7 The Pie Again 20.8 Corporate versus Personal Borrowing 20.9 Observed Capital Structures 20.10 Summary and Conclusions Chapter Organisation

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-3 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. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-4 The Capital Structure Question Key issues – What is the relationship between capital structure and firm value? – What is the optimal capital structure? Cost of capital – A firm’s capital structure is chosen if WACC is minimised. – This is known as the optimal capital structure or target capital structure.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-5 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.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-6 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

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-7 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

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-8 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

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-9 Example—Home-made Leverage and ROE Home-made leverage is the use of personal borrowing to alter the degree of financial leverage. Investors can replicate the financing decisions of the firm in a costless manner. Example 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.

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-10 Original Capital Structure and Home- made Leverage

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-11 Proposed Capital Structure

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-12 Capital Structure Theory Modigliani and Miller 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

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-13 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

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-14 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)

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-15 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.

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-16 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]).

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-17 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)

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-18 The SML and M&M Proposition II 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).

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-19 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.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-20 Corporate Taxes Tax saving = $16 = 0.40 x $40 = T C × R D × D

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-21 Corporate Taxes 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 resultV L = V U + T C D

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-22 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

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-23 Taxes, the 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

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-24 Taxes, the 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 )

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-25 Taxes, the WACC and Propositions I and II—Conclusions The WACC decreases as more debt financing is used. Optimal capital structure is all debt.

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-26 Debt-equity ratio, D/E Cost of capital (%) RURU R D  (1 – T C ) RERE WACC RERE RURU R D  (1 – T C ) Taxes, the WACC and Proposition II

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-27 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.

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-28 Direct versus Indirect Bankruptcy Costs Direct costs Those costs directly associated with bankruptcy, (e.g. legal and administrative expenses). Indirect costs Those costs associated with spending resources to avoid bankruptcy. Financial distress: – significant problems in meeting debt obligations – most firms that experience financial distress do recover.

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-29 Direct versus Indirect Bankruptcy Costs 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.

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-30 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

31. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-31 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

32. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-32 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

33. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-33 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.

34. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-34 Lower financial leverage Bondholder claim Bankruptcy claim Tax claim Shareholder claim Higher financial leverage Bondholder claim Bankruptcy claim Tax claim Shareholder claim The Extended Pie Model

35. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-35 The Value of the Firm Value of the firm = marketed claims + non- marketed claims: – Marketed claims are the claims of shareholders and bondholders. – Non-marketed claims are the claims of the government and other potential stakeholders. The overall value of the firm is unaffected by changes in the capital structure. The division of value between marketed claims and non-marketed claims may be impacted by capital structure decisions.

36. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-36 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.

37. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 20-37 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.