1. Financial Leverage and Capital Structure Policy
Chapter 16
Financial Leverage and Capital Structure Policy

2. Key Concepts and Skills
The capital structure question
Understand the impact of taxes and bankruptcy on capital structure choice
Capital structure and the cost of equity capital
Bankruptcy costs
Optimal capital structure

3. Financial Leverage
Refers to 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.

4. 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

5. 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

6. 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

7. Example: Financial Leverage, EPS and ROE
What happens to EPS and ROE when we issue debt and buy back shares of stock?
Current and proposed capital structures for the Trans corporation:
Proposed
Current
8,000,000
Asset
4,000,000
Debt
Equity 1
Debt-equity ratio 20
Share price
200,000
400,000
Shares outstanding
10%
Interest rate

8. Example: Financial Leverage, EPS and ROE
Current Capital Structure : No Debt
Expansion
Expected
Recession
$1,500,000
$1,000,000
$500,000
EBIT
Interest
1,500,000
1,000,000
500,000
Net income
18.75%
12.5%
6.25%
ROE
3.75
2.5
1.25$
EPS
Proposed Capital Structure : Debt= 4$ million
400,000
1,100,000
600,000
100,000
27.50%
15.00%
2.5%
5.5 3
$ 0.5

9. Example: Financial Leverage, EPS and ROE
Variability in ROE
Current: ROE ranges from 6.25 % to %
Proposed: ROE ranges from 2.5 % to %
Variability in EPS
Current: EPS ranges from $ 1.25 to $ 3.75
Proposed: EPS ranges from $ 0.5 to $ 5.5
The variability in both ROE and EPS increases when financial leverage is increased

10. 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

11. Capital Structure Theory
Modigliani and Miller (M&M)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

12. Capital Structure Theory Under Three Special Cases
Case I – Assumptions
No corporate or personal taxes
No bankruptcy costs
Case II – Assumptions
Corporate taxes, but no personal taxes
Case III – Assumptions
Bankruptcy costs

13. Case I – Propositions I and II
Proposition I
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
Proposition II
The WACC of the firm is NOT affected by capital structure

14. Case I - Equations WACC = RA = (E/V)RE + (D/V)RD
RE = RA + (RA – RD)(D/E)
RA is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets
(RA – RD)(D/E) is the “cost” of the firm’s financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage

15. Figure 16.3

16. Case I - Example Data 1- What is the cost of equity & WACC?
Required return on assets = 12%; cost of debt = 8%;
1- What is the cost of equity & WACC?
RE = 13%
WACC = 12 %
2- What is the cost of equity & WACC?
RE = 16%

17. Business Risk and Financial Risk
Systematic risk of the assets, A, (Business risk)
Level of leverage, D/E, (Financial risk)

18. Case II – Cash Flow 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?

19. Case II - Example Firm L Firm U $1,000 EBIT 80 Interest $920
Interest
$920
Taxable Income
276
300
Taxes (30%)
$644
$700
Net income
Firm L
Firm U
Cash Flow from Assets
1,ooo
EBIT
276
300
-Taxes
$724
$700
Total
Firm L
Firm U
Cash Flow
644
700
To stockholders 80
To bondholders
$724
$700
Total

20. Interest Tax Shield Tnterest Tax Shield :
The tax saving attained by a firm from interest expense.
Annual interest tax shield
Tax rate times interest payment
Annual tax shield = .30(80) = $24
Present value of annual interest tax shield
Assume perpetual debt for simplicity
PV = 24 / .08 = $300
PV =(TC × D×RD ) / RD =TC × D = 1000 × .30 = $300

21. Figure 16.4

22. Case II – Proposition I
The value of the firm increases by the present value of the annual interest tax shield
Value of a levered firm = value of an unlevered firm + PV of interest tax shield
VL = VU + DTC
Value of equity = Value of the firm – Value of debt
Assuming perpetual cash flows
VU = EBIT(1-T) / RU

23. The Static Theory of Capital Structure
The theory that 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.

24. Case III

25. Case III Capital Structure: Some Managerial Recommendations: Taxes:
Firms that have substantial tax shields from other sources, such as depreciation, will get less benefit from leverage
The higher the tax rate, the greater in incentive to borrow
Financial Distress:
Firms with a greater risk of experiencing financial distress will borrow less than firm with a lower risk of financial distress (EBIT)
Financial distress costs will be determined by how easily ownership of those assets can be transferred (tangible)

26. The Pecking-Order Theory
Firms prefer to use internal financing whenever possible.

27. 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

28. More 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

29. Bankruptcy Process Liquidation Reorganization
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 Federal Bankruptcy Reform Act of 1978
Restructure the corporation with a provision to repay creditors