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**Financial Leverage and Capital Structure Policy**

Chapter 16

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**Capital Restructuring**

What is meant by capital restructuring What is the primary goal of financial managers? Can leverage help in achieving such goals?

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**Capital Restructuring**

We are going to look at how changes in capital structure affect the value of the firm, all else equal Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets The firm can increase leverage by issuing debt and repurchasing outstanding shares The firm can decrease leverage by issuing new shares and retiring outstanding debt

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**Choosing a Capital Structure**

What is the primary goal of financial managers? Maximize stockholder wealth We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC

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**Financial Leverage 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

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**Financial leverage, EPS, and ROE: an example**

proposed current 8,000,000 Asset 4,000,000 debt Equity 1 Debt-equity ratio 20 Share price 200,000 400,000 Shares out standing 10% Interest rate

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**Financial leverage, EPS, and ROE: an example**

Current capital structure : No Debt expansion expected Recession 1,500,000 1,000,000 500,000 EBIT Interest Net income 18.75% 12.5% 6.25% ROE 3.75 2.5 1.25 EPS Proposed capital structure : debt= 4$ million 400,000 1,100,000 600,000 100,000 27.5% 15% 2.5% 5.5 3 0.5$

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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 is beneficial to our stockholders If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders

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Ex 1 Page 540 Maynard, Inc., has no debt outstanding and a total market value of 250,000$. EBIT are projected to be 28,000$ if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 50 percent lower. Maynard is considering a 90,000$ debt issue with a 7 percent interest rate. The proceeds will be used to repurchase a share of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem Calculate EPS under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession. Repeat part (a) assuming that the economy goes with recapitalization. What do you observe?

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Ex 4 Page 542 James Corporation is comparing two different capital structures: an all equity plan (plan I) and a levered plan (plan II). Under plan I, the company would have 160,000 shares of stock outstanding. Under plan II, there would be 80,000 shares of stock outstanding and 2.8$ million in debt outstanding. The interest rate on the debt is 8 percent and there are no taxes. If EBIT is 350,000$, which plan will result in the higher EPS? If EBIT is 500,000$, which plan will result in the higher EPS? What is the break-even EBIT?

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**Corporate borrowing & home made leverage**

The effect of leverage depends on the company’s EBIT. When EBIT is relatively high, leverage is beneficial Under the expected scenarios, leverage increase the returns to shareholders, as measured by both ROE and EPS Shareholders are exposed to more risk under the proposed capital structure because the EPS and ROE are much more sensitive to changes in EBIT in this case Because of the impact that financial leverage has on both the expected return to stockholder and the riskiness of the stock, capital structure is an important consideration

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**Corporate borrowing & home made leverage**

Homemade leverage: the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.

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**Corporate borrowing & home made leverage**

Proposed capital structure expansion expected recession 5.5$ 3$ 0.5$ EPS 550 300 50 Earnings for 100 shares Original capital structure and homemade leverage 3.75 2.5 1.25 750 500 250 Earnings for 200 shares 200 Less: interest on $2,000 at 10% Net earnings

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Ex 9 Page 543 ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with 600,000$ in stock. XYZ uses both stock and perpetual debt; its stock is worth 300,000$ and the interest rate on its debt is 8 percent. Both firms expect EBIT to be 80,000$ Rico owns 30,000$ worth of XYZ’s stock. What rate of return is he expecting? Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage?

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**Capital Structure Theory**

Modigliani and Miller (M&M)Theory of Capital Structure Proposition I: the value of the firm is independent of the firm’s capital structure The value of the firm is NOT affected by changes in the capital structure The cash flows of the firm do not change; therefore, value doesn’t change (THE PIE MODEL)

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**Capital Structure Theory**

Proposition II The firm’s cost of equity capital is a positive linear function of the firm’s capital structure RE = RA + (RA – RD)(D/E) The cost of equity depends on three things The WACC of the firm is NOT affected by capital structure

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**Capital Structure Theory**

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**Example What is the cost of equity?**

Required return on assets = 16%; cost of debt = 10%; debt=45% What is the cost of equity? Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio? Based on this information, what is the percent of equity in the firm?

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**M & M proposition I and II with corporate taxes**

Interest is tax deductible Therefore, when a firm adds debt, it reduces taxes, all else equal The reduction in taxes increases the cash flow of the firm How should an increase in cash flows affect the value of the firm?

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**M & M proposition I and II with corporate taxes**

Firm L Firm U 1,000 EBIT 80 I 920 Taxable income 276 300 Taxes (30%) 644 700 NI

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**M & M proposition I and II with corporate taxes**

Firm L Firm U CFFA 1,ooo EBIT 276 300 Taxes 724 700 total Firm L Firm U Cash flow 644 700 To stock holder 80 To bond holder 724 total

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**M & M proposition I with taxes**

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**M & M proposition I and II with corporate taxes**

Interest tax shield: the tax saving attained by a firm from interest expense Proposition I with taxes: Value of a levered firm = value of an unlevered firm + PV of interest tax shield VL = VU + DTC

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Example EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% Calculate the PV of VU, VL?

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**Proposition II with taxes**

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Ex 10 Page 543 Wood Crop. Uses no debt. The WACC is 9 percent. If the current market value of the equity is 23$ million and there are no taxes, what is EBIT?

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Ex 11 Page 543 In the previous question suppose that corporate tax rate is 35 percent. What is EBIT? What is the WACC? Explain?

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Ex 14 Page 543 Frederick & Co. expects its EBIT to be 92,000$ every year for ever. The firm can borrow at 9 percent. Frederick currently has no debt, and its cost of equity is 15 percent. If the tax rate is 35 percent, what is the value of the firm? What will the value be if the company borrows 60,000$ and uses the proceeds to repurchase shares?

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Ex 15 Page 544 In problem 14, what is the cost of equity after recapitalization? What is the WACC? What are the implications for the firm’s capital structure decision?

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**Bankruptcy Costs Direct costs Financial distress**

Legal and administrative costs Ultimately cause bondholders to incur additional losses Disincentive to debt financing Financial distress Significant problems in meeting debt obligations Firms that experience financial distress do not necessarily file for bankruptcy

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**Bankruptcy Costs Indirect bankruptcy costs**

Larger than direct costs, but more difficult to measure and estimate Stockholders want to avoid a formal bankruptcy filing Bondholders want to keep existing assets intact so they can at least receive that money Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business The firm may also lose sales, experience interrupted operations and lose valuable employees

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**Optimal Capital Structure**

The static theory of capital structure:

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**Optimal Capital Structure and the cost of capital**

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**Conclusions Case I – no taxes or bankruptcy costs**

No optimal capital structure Case II – corporate taxes but no bankruptcy costs Optimal capital structure is almost 100% debt Each additional dollar of debt increases the cash flow of the firm Case III – corporate taxes and bankruptcy costs Optimal capital structure is part debt and part equity Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs

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**Managerial recommendations**

Taxes Financial distress

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