Chapter 12: Leverage and Capital Structure

Capital structure decision Capital structure decisions: The decisions about a firm’s debt-equity ratio How should a firm choose its debt-equity ratio? Guiding principle: Choose a ratio that maximize the value of the firm The value of the firm is maximized when the WACC (discount rate for the firm’s future cash flows) is minimized Optimal capital structure or target capital structure is one that minimizes its WACC

The effect of financial leverage Financial leverage refers to the extent to which a firm relies on debt How financial leverage works?

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 fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE Remind the students that if we increase the amount of debt in a restructuring, we are implicitly decreasing the amount of outstanding shares. 16-4

Financial Leverage, EPS, and ROE Consider an all-equity firm that is considering going into debt. (Issue debt to buy back stock.) Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 The firm borrows $8,000 and buys back 160 shares at $50 per share.

EPS and ROE Under Current Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares

EPS and ROE Under Proposed Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 1.8% 6.8% 11.8% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

EPS and ROE Under Both Capital Structures All-Equity Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares Levered Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 1.8% 6.8% 11.8% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

Financial Leverage and EPS 12.00 Debt 10.00 8.00 No Debt 6.00 Advantage to debt Break-even point EPS 4.00 2.00 0.00 1,000 2,000 3,000 Disadvantage to debt (2.00) EBIT EBI in dollars, no taxes

Break-Even EBIT Find EBIT where EPS is the same under both the current and proposed capital structures If we expect EBIT to be greater than the break-even point, then leverage may be beneficial to our stockholders If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders Lecture Tip: Many students feel that if a company expects to achieve the break-even EBIT, it should automatically issue debt. You should emphasize that this is a break-even point relative to EBIT and EPS. Beyond this point, EPS will be larger under the debt alternative, but with additional debt, the firm will have additional financial risk that would increase the required return on its common stock. A higher required return might offset the increase in EPS, resulting in a lower firm value despite the higher EPS. The M&M models, described in upcoming sections, will offer key points to make about this relationship. 16-10

Break-even EBIT You are considering two different capital structures. The first option consists of 20,000 shares of stock. The second option consists of 10,000 shares of stock plus $200,000 of debt with an interest rate of 8%. Ignore taxes. What is the break-even level of EBIT between these two options?

Break-even EBIT

Homemade Leverage The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed Investors can always increase financial leverage themselves It makes no difference to investors whether or not companies change capital structures

Homemade Leverage: An Example Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300 Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3% 11% 20% We are buying 40 shares of a $50 stock on margin. We get the same ROE as if we bought into a levered firm. Our personal debt equity ratio is:

Homemade (Un)Leverage: An Example Recession Expected Expansion EPS of Levered Firm $1.50 $5.67 $9.83 Earnings for 24 shares $36 $136 $236 ROE (Net Profits / $1,200) 3% 11% 20% Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm. This is the fundamental insight of M&M

Homemade leverage ABCO, Inc. has EBIT of $100,000. There are 50,000 shares of stock outstanding at a market price of $20 a share. ABCO has just decided to issue $400,000 of debt at a rate of 8% to repurchase shares of stock. Fred owns 20,000 shares of ABCO stock. Fred wants to use homemade leverage to offset the leverage being assumed by ABCO. How many shares of ABCO stock must Fred sell to achieve his goal if he loans out the funds from the stock sale at 8% interest?

Homemade leverage No Debt Debt EBIT $100,000 $100,000 Interest ______0 ? Net income $100,000 ? # of shares 50,000 ? EPS $2.00 ?

Homemade leverage

Homemade leverage No Debt Debt EBIT $100,000 $100,000 Interest 0 32,000 Net income $100,000 $ 68,000 # of shares 50,000 30,000 EPS $2.00 $2.2667

Homemade leverage Unlevered: 20,000 shares  $2.00 = $40,000 Levered:

Homemade leverage Weights Stock: 30,000  $20 = $ 600,000 60% Debt: = $ 400,000 40% Total: $1,000,000 100%

Homemade leverage Investment = 20,000  $20 = $400,000 Stock: 60% of $400,000 = $240,000 $240,000  $20 = 12,000 shares Loan out: 40% of $400,000 = $160,000

Homemade leverage No company debt and no homemade leverage: 20,000 shares  $2.00 = $40,000 Homemade leverage used to offset firm leverage: Stock: 12,000  $2.2667 = $27,200 Loan: $400,000  .08 = $12,800 Total: $40,000

Assumptions of the Modigliani-Miller Model Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets: Perfect competition Firms and investors can borrow/lend at the same rate Equal access to all relevant information No transaction costs No taxes

The MM Propositions I & II (No Taxes) Proposition I Firm value is not affected by leverage VL = VU Proposition II Leverage increases the risk and return to stockholders rE = r0 + (D / EL) (r0 - rD) rD is the interest rate (cost of debt) rE is the return on (levered) equity (cost of equity) r0 is the return on unlevered equity (cost of capital) D is the value of debt EL is the value of levered equity

The MM Proposition I (No Taxes) The derivation is straightforward: The present value of this stream of cash flows is VL The present value of this stream of cash flows is VU

The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes Cost of capital: r (%) r0 rB rD Debt-to-equity Ratio

M&M Proposition I, no tax A debt-free firm currently has 400,000 shares of stock outstanding. The company is considering reducing the number of shares to 300,000. To do this, the firm will have to borrow $5 million at 8% interest. Ignoring taxes, what is the value of the firm?

M&M Proposition I, no tax

M&M Proposition II, no tax Walter’s Store has a debt/equity ratio of .60. The required return on assets is 12% and the pre-tax cost of debt is 8%. Ignore taxes. What is the cost of equity?

M&M Proposition II, no tax

The MM Propositions I & II (with Corporate Taxes) Proposition I (with Corporate Taxes) Firm value increases with leverage VL = VU + TC D Proposition II (with Corporate Taxes) Some of the increase in equity risk and return is offset by interest tax shield rE = r0 + (D/E)×(1-TC)×(r0 - rD) rD is the interest rate (cost of debt) rE is the return on equity (cost of equity) r0 is the return on unlevered equity (cost of capital) D is the value of debt E is the value of levered equity

The MM Proposition I (Corp. Taxes) The present value of this stream of cash flows is VL The present value of the first term is VU The present value of the second term is TCD

The MM Proposition II (Corp. Taxes) Start with M&M Proposition I with taxes: Since The cash flows from each side of the balance sheet must equal: Divide both sides by S Which quickly reduces to

The Effect of Financial Leverage on the Cost of Debt and Equity Capital Cost of capital: r (%) r0 rB Debt-to-equity ratio (D/E)

M&M Proposition I with tax The Bigely Co. has $5,000 worth of debt outstanding that is selling at par. The coupon rate is 9% and the company tax rate is 34%. What is the amount of the annual tax shield? What is the present value of the tax shield?

M&M Proposition I with tax

M&M Proposition I with tax Dawn, Inc. has 150,000 shares of stock outstanding at a market price of $30 a share. The cost of equity is 10%. The company is considering adding $1.5 million of debt with a coupon rate of 7%. The debt will sell at par. The tax rate is 35%. What will the value of Dawn, Inc. be after they add the debt to their capital structure? What is the levered value of the equity?

M&M Proposition I with tax

M&M Proposition I with tax The Baker Co. has an unlevered cost of capital of 12% and a tax rate of 35%. The expected EBIT is $1,200. The company has $3,000 of debt which is selling at par. The coupon rate is 8%. What is the value of the firm?

M&M Proposition I with tax

M&M Proposition II with tax Charlie & Co. has $2,500 in bonds outstanding that are selling at par. The bonds have a 7% coupon rate and pay interest annually. The expected EBIT is $1,400 and the unlevered cost of capital is 10%. The tax rate is 35%. What is the cost of equity?

M&M Proposition II with tax

M&M Proposition II with tax

M&M Proposition II with tax

M&M Proposition II with tax Using the information from the last problem, you have debt of $2,500, equity of $7,475, VL of $9,975, RD of 7%, RE of 10.65% and a tax rate of 35%. What is the weighted average cost of capital (WACC)?

M&M Proposition II with tax

Summary: No Taxes In a world of no taxes, the value of the firm is unaffected by capital structure. This is M&M Proposition I: VL = VU Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders

Summary: Taxes In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage. This is M&M Proposition I: VL = VU + TC D Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.

Prospectus: Bankruptcy Costs So far, we have seen M&M suggest that financial leverage does not matter, or imply that taxes cause the optimal financial structure to be 100% debt. In the real world, most executives do not like a capital structure of 100% debt because that is a state known as “bankruptcy”. In the next chapter we will introduce the notion of a limit on the use of debt: financial distress. The important use of this chapter is to get comfortable with “M&M algebra”.

Capital Structure Structure of Bond Yield Rates r D E Bond Yield The more debt the company uses, the higher its bond yield because of higher risk 51

WACC w/o taxes (traditional view) Includes Bankruptcy Risk rE WACC rD D V 52

Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. 53

Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress => Trade-off theory of capital structure 54

Financial Distress Market Value of The Firm Debt Maximum value of firm Costs of financial distress Market Value of The Firm PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt Debt 55