Financial Management FIN300 Leverage and Capital Structure

Objectives Upon completion of this lesson, you will be able to: –Discuss the effect of financial leverage –Analyze the impact of taxes and bankruptcy on capital structure choice –Identify the essentials of the bankruptcy process

Choosing a Capital Structure What is the primary goal of financial managers? –Maximize shareholder value We want to choose the capital structure that will maximize shareholder value We can maximize shareholder value by maximizing firm value or minimizing WACC

The Effect of Leverage How does leverage affect the EPS and ROE of a firm? –When we increase the amount of debt financing, we increase the amount of interest expense –If we have a really good year, then we pay our interest costs and we have more left over for our stockholders –If we have a really bad year, we still have to pay our interest costs and we have less left over for our stockholders –Leverage amplifies the variation in both EPS and ROE and increases the risk of equity, which is called financial risk

Issuing New Debt to Repurchase Stock Effect on value of firm before any tax effects –Pretax cost of debt is lower than cost of equity –Risk of stock will increase, thereby increasing cost of equity –Asset structure remains the same, as does required return on assets, which is equal to the WACC –Change in capital structure has no effect on value of the firm or on WACC –EBIT remains the same

Tax Effect of Leverage Effect on value of profitable firm after tax effects –Where EBIT remains the same –Interest on debt reduces taxable income, or EBT, thereby reducing taxes –CFFA increases

Example: Leverage Effect on CFFA Unlevered Firm Levered Firm EBIT5,000 Interest0500 Taxable Income5,0004,500 Taxes (34%)1,7001,530 Net Income3,3002,970 CFFA3,3003,470

Example: Leverage Effect on ROE and EPS Unlevered Firm Levered Firm Debt 0 5,000 Equity 15,000 10,000 Shares 3,000 2,000 Net Income 3,300 2,970 ROE 3.3/15 = 22% 2.97/10 = 29.7% EPS 3.3/3 = $ /2 = $1.49

Measuring Risk Effect of Leverage WACC = R A = (E/V)R E + (D/V)R D R E = R A + (R A – R D )(D/E) –R A is the cost of the firm’s systematic or business risk, the risk of the firm’s assets –(R A – R D )(D/E) is the cost of the firm’s financial risk, the additional return required by stockholders to compensate for the risk of leverage

Optimal Capital Structure Leverage can increase –Return on equity –Earnings per share –Stockholder value Increased leverage can result in –Higher required return on equity –Higher required interest rate on debt Conclusion –There are limits to the value of leverage

Bankruptcy Costs If our firm defaults on payment of interest or principle, the bondholders can force us into bankruptcy As the D/E ratio increases, the probability of bankruptcy increases This increased probability will increase the expected costs of bankruptcy or of avoiding bankruptcy At some point, the additional value of the interest tax shield will be offset by the financial distress costs At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added

Bankruptcy Costs, continued Direct costs –Legal and administrative costs –Ultimately cause bondholders to incur additional losses –Disincentive to debt financing Financial distress –Significant problems in meeting debt obligations –May have to sell productive assets –Most firms that experience financial distress do not ultimately file for bankruptcy

Bankruptcy Process Liquidation –Chapter 7 of the Federal Bankruptcy Reform Act of 1978 –Trustee takes over assets, sells them, and distributes the proceeds according to the absolute priority rule Reorganization –Chapter 11 of the act –Restructure the corporation with a provision to protect creditors –May including rescinding contractual obligations such as leases or union contracts

Check Your Understanding

Summary Effect of financial leverage Taxes and bankruptcy Bankruptcy process