1. © Prentice Hall, 2000 1 Chapter 14 Establishing a Target Capital Structure Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

2. © Prentice Hall, 2000 2 Learning Objectives è Describe the effects of financial leverage on equity risks and return. è Use EBIT-EPS indifference analysis to evaluate financing alternatives. è Explain why capital structure doesn’t matter in a world without taxes, transactions costs, or other market imperfections. è Explain the existence of an optimal capital structure in terms of the trade-offs between the tax advantages of debt and the expected costs of financial distress. è Identify those elements of business risk which influence the probability of financial distress.

3. © Prentice Hall, 2000 3 Learning Objectives (Cont.) è Discuss how the possibility of financial distress may affect management behavior. è Explain how agency costs can affect a firm’s financing strategy. è Explain how leveraged recapitalizations such as leveraged buyouts can mitigate the agency costs of equity. è Discuss how financing flexibility and the needs for financial reserves can influence the capital structure choice.

4. © Prentice Hall, 2000 4 Financial Leverage and Financial Risk è Financial Leverage - The substitution of fixed cost financing for common stock. è Business Risk - The inherent variability of a firm’s operating earnings. è Financial Risk - The risk shareholders bear for the firm’s use of financial leverage.

5. © Prentice Hall, 2000 5 Effects of Financial Leverage on ROE Where: r A = return on assets before financing costs i = after-tax cost of debt D = amount of debt in the capital structure E = amount of equity in the capital structure

6. © Prentice Hall, 2000 6 Consequences of Leverage - An Example Hi-Tech Running Shoes needs $5 million in assets to support sales. Option A: Issue 500,000 shares @ $10/share Option B: Issue 250,000 shares @ $10/share; $2.5 million in debt @ 10% Expected EBIT = $1,000,000; EBIT (Low Estimate) = $200,000; EBIT (High Estimate) $2,000,000

7. © Prentice Hall, 2000 7 Consequences of Leverage - An Example Effect of leverage on Hi-Tech’s Earnings Per Share States of the World BadMediocre Normal Good No Leverage 500,000 shares @ $ 10/share EBIT $200,000$500,000 $1,000,000$2,000,000 Less: Interest@ 10% 00 0 0 Equity Income $200,000$500,000 $1,000,000$2,000,000 Less: Tax @ 50% 100,000 250,000 500,000 1,000,000 Equity income after tax $100,000$250,000 500,000 $1,000,000 EPS $.20 $.50 $1.00 $2.00 ROE (%) 25 10 20

8. © Prentice Hall, 2000 8 Consequences of Leverage - An Example Effect of leverage on Hi-Tech’s Earnings Per Share States of the World BadMediocre Normal Good 50 percent debt 250,000 shares @ $ 10/share; $2.5 million in debt @10% interest EBIT $200,000$500,000 $1,000,000$2,000,000 Less: Interest@ 10% 250,000 250,000 250,000 250,000 Equity Income ($50,000)$250,000 $750,000$1,750,000 Less: Tax @ 50% ($25,000) 125,000 375,000 875,000 Equity income after tax ($25,000)$125,000 $375,000 $875,000 EPS ($.10) $.50 $1.50 $3.50 ROE (%) -15 15 35

9. © Prentice Hall, 2000 9 EBIT - EPS Indifference Point Where: EBIT* = EBIT-EPS indifference point I A,I B = interest expense under plan A and B P A,P B = preferred stock dividends under plan A and B t c = corporate tax rate N A,N B = number of shares outstanding under plan A and B

10. © Prentice Hall, 2000 10 Hi-Tech’s EBIT - EPS Indifference Point

11. © Prentice Hall, 2000 11 Effects of Financial Leverage on Risk and Return è When ROA exceeds the after-tax interest cost of debt, financial leverage increase both EPS and ROE. è Financial leverage increase the variability of EPS and ROE. è Financial leverage increases the expected level of EPS and ROE.

12. © Prentice Hall, 2000 12 Traditional Approach to Capital Structure According to the traditional approach to capital structure, the prudent use of debt can lower the firm’s overall cost of capital and thereby increase its market value.

13. © Prentice Hall, 2000 13 Traditional Approach to Capital Structure - A Graphical View Debt/Total Equity Required return k e = Cost of equity capital L* k 0 = Weighted Average Cost of Capital k d = Cost of debt capital

14. © Prentice Hall, 2000 14 Modigliani and Miller’s Proposition I In the absence of taxes, transaction costs and other market imperfections, the value of firm is independent of its capital structure.

15. © Prentice Hall, 2000 15 Modigliani and Miller’s Proposition I - An Example Suppose two firms are identical in all respects except for capital structure. Firm U is unlevered, and Firm L has $1 million in 10 percent debt. Both firms have an expected EBIT of $500,000.

16. © Prentice Hall, 2000 16 Modigliani and Miller’s Proposition I - An Example Suppose the two firms have the following valuations: Firm U Firm L EBIT$500,000 $500,000 Interest 0 100,000 Dividends$500,000$400,000 Cost of Equity 0.15 0.16 Market Value of Equity $3,333,333 $2,500,000 Market Value of Debt 0 1,000,000 Market Value of Firm $3,333,333 $3,500,000

17. © Prentice Hall, 2000 17 Modigliani and Miller’s Proposition I - An Example Suppose you owned 10 percent of L’s stock with a market value of $250,000. According to MM, you should 1. Sell off your shares in L for $250,000 2. Borrow an amount equal to 10 percent of L’s debt ($100,000) at an interest rate of 10 percent 3. Buy 10 percent of the shares of U for $333,333 With these transactions you would receive $350,000 in cash for the sale of your stock in L, plus your borrowing, whereas you would be spending only $333,000 to buy U’s stock. You would earn $16,667 from this transaction in uncommitted funds.

18. © Prentice Hall, 2000 18 Modigliani and Miller’s Proposition I - An Example The effects of these financial transactions on your income will be Old income From New Income From Investment in LInvestment in U 10% Firm’s Equity Income$500,000 $500,000 Interest Expense on Borrowing 0 100,000 Net Income$500,000$400,000 Investment income from the common stock is the same in both cases, but now you have $16,668 to spend as you please.

19. © Prentice Hall, 2000 19 Modigliani and Miller’s Proposition II The cost of equity capital for a levered firm equals the overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt.

20. © Prentice Hall, 2000 20 The MM’s Proposition II - A Graphical Representation Debt / Equity Required return (k 0 ) (k e ) (k d )

21. © Prentice Hall, 2000 21 MM with Corporate Taxes Consider two firms are identical in all respects except for capital structure. Firm U is unlevered, and Firm L has $1 million in 10 percent debt. Both firms have an expected EBIT of $500,000 and marginal tax rates of 40 percent.

22. © Prentice Hall, 2000 22 MM with Corporate Taxes Income Statement Firm U Firm L Earning Before Interest and Taxes$500,000 $500,000 Interest Paid to Bondholders 0 100,000 Pre-tax Profits$500,000$400,000 Taxes @ 40% 200,000 160,000 Income to Stockholders $300,000 $240,000 Income to Stockholders and Bondholders$300,000 $340,000 Interest Tax Shield (Interestx0.40) 0 $40,000 Present Value of Tax Shield0 400,000

23. © Prentice Hall, 2000 23 MM with Corporate Taxes In a world where the only market imperfection is corporate taxes, the value of a levered firm (V L ) equal the value of an unlevered firm (V U ) plus the present value of the debt tax shields:

24. © Prentice Hall, 2000 24 Financial Leverage and Financial Distress è Financial Distress - A situation where a firm has difficulty meeting its contractual obligations. è Bankruptcy - An extreme form of financial distress where a firm defaults on its obligations and is placed under the protection of the court until a place is devised to pay creditors.

25. © Prentice Hall, 2000 25 Financial Leverage and Financial Distress - A Graphical View Market value of the firm L* = optimal debt ratio Value of firm with debt financing Debt Ratio Value of firm if all-equity financed PV costs of financial distress PV of interest tax shield

26. © Prentice Hall, 2000 26 Probability of Financial Distress For any given level of debt, the higher the business risk, the greater will be the likelihood of financial distress. Determinants of business risk are: è The Firm’s Cost Structure è Demand Stability è Competition è Price Fluctuations è Firm Size and Diversification è Stage in the Industry Life Cycle

27. © Prentice Hall, 2000 27 Costs of Financial Distress - Adverse Selection è Selection of High-Risk Projects è Foregoing Low-Risk Positive NPV Projects è Myopic Decision Making

28. © Prentice Hall, 2000 28 Cost of Financial Distress - Industry Characteristics Industry-specific characteristics that argue for low debt ratios include the following: èProducts that require repairs èGood/Services where quality is an important attribute, but where it is difficult to access in advance èProducts for which there are switching costs èProducts whose value to the customer depends on services and/or complementary products supplied by other firms

29. © Prentice Hall, 2000 29 Cost of Financial Distress - Industry Characteristics Firm-specific characteristics that argue for low debt ratios include the following: èHigh growth opportunities èSubstantial Organizational assets èLarge excess tax deductions

30. © Prentice Hall, 2000 30 Agency Costs and Capital Structure è Stockholder-Manager Conflicts èExcessive Perk Consumption èShrinking Responsibility è Stockholder-Bondholder Conflicts èShareholder incentive to take on high-risk projects èShareholder incentive to pass up certain positive NPV projects

31. © Prentice Hall, 2000 31 Agency Cost of Debt è Costs of monitoring to insure that they are not exploited by shareholders. è Control costs in the form of restrictive covenants.

32. © Prentice Hall, 2000 32 Agency Costs of Equity è Management’s interest in the firm decreases as “outside” equity increases. è Incentives to expand the size of the firm èReduce dividend payments èInvest in substandard projects

33. © Prentice Hall, 2000 33 Reducing Agency Costs of Equity - Expanding Leverage One answer to the agency costs of equity is through a leveraged recapitalization that restricts management’s discretion over free cash flows by boosting debt and shrinking equity. Two ways of doing this are: è Leveraged Cash-Out è Leveraged Buyout

34. © Prentice Hall, 2000 34 Strategic Factors Influencing Capital Structure è Financial Flexibility and Corporate Strategy è Value of Financial Reserves èLess valuable for well-established, publicly traded firms èMost valuable for privately held firms, small companies, or firms that the market has difficulty in valuing