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課程 12: Financial Leverage and Capital Structure Policy

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How to decide the optional capital structure?

• What’s the objective?– maximize firm value– maximize firm value– minimize WACC

• A particular debt/equity ratio represents the optional capital structure if it results in the lowest possible WACC.

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Financial Leverage 財務槓桿／ Financial Risk 財務風險

Financial leverage affects the payoffs to stockholders.

An example:

Panel A: Current capital structure: no debt

Recession Expected ExpansionEBIT 500000 1000000 1500000interest 0 0 0net income 500000 1000000 1500000ROE 6.25% 12.50% 18.75%EPS 1.25 2.5 3.75

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• Panel B: Proposed capital structure: debt = 4 million

Recession Expected ExpansionEBIT 500000 1000000 1500000interest 400000 400000 400000net income 100000 600000 1100000ROE 2.50% 15.00% 27.50%EPS 0.5 3 5.5

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EPS vs. EBIT 每股盈餘無異分析

EPS with debt

Good no debt

No good

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Break-even point

• EPS will be the same for both capital structures:

800000

200000

40000

400000*

EBIT

EBITEBIT

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Example

• Before: 200,000 shares * $20 @ share = $4,000,000

• Debt 1,000,000

• After 3,000,000

/20

150,000 shares

360000

150000

40000

200000*

EBIT

EBITEBIT

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Conclusion

• The effect of financial leverage depends on the firm’s EBIT. When EBIT is relatively high, leverage is beneficial.

• Shareholders are exposed to more risk under the proposed capital structure since the EPS and ROE are much more sensitive to change in EBIT.

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Question

• Because of the impact that financial leverage has on both the expected return to stockholders and the riskness of the stock, capital structure is an important consideration.

• Answer: no.

• ∵Shareholders can adjust the amount of financial leverage by borrowing and lending on their own. The use of personal borrowing to alter the degree of financial leverage is called homemade leverage.

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Homemade leverage

• Panel A: proposed capital structure

Recession Expected ExpansionEPS 0.5 3 5.5Earnings for 100 shares 50 300 550Net cost 100*20=2000

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• Panel B: original capital structure and homemade leverage

Recession Expected ExpansionEPS 1.25 2.5 3.75Earnings for 200 shares 250 500 750Less: interest on 2000 at 10% 200 200 200Net earnings 50 300 550Net cost 200*20-amount borrowed=4000-2000=2000

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• Investors can always increase financial leverage themselves to create a different pattern of payoffs. It thus makes no different whether a firm restructure the capital structure.

• There is nothing special about corporate borrowing because investors can borrow or lend on their own. As a result, whichever capital structure a firm chooses, the stock price will be the same.

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M&M proposition I: Modigliani and Miller

• The value of the firm is independent of its capital structure.

• Example:• .firm value distribution: stockholders vs. debtholder

s.

• .whole milk: cream vs. skim milk.

• .pie: more pieces, but not more pizza. The size of the pizza does not depend on how it is sliced.

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M&M proposition II

• A firm’s cost of equity is a positive linear function of its capital structure.

assuming no taxDEA R

V

DR

V

ERWACC

E

DRRRR DAAE

RE

RE

WACCRD

D/E

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M&M propositions with corporate tax

• Properties of debt

– tax benefit vs. bankruptcy cost

• Example:

Firm U: unlevered, Firm L: levered.

Assuming two firms are identical on the left-hand side of the balance sheet, only different on capital structure.

Firm U Firm LEBIT 1000 1000Interest 0 80Taxable income 1000 920Taxed(30%) 300 276Net income 700 644

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• The interest tax shield

• Cash flow to stockholders and bondholders

Cash flows from assets Firm U Firm LEBIT 1000 1000－taxes 300 276Total 700 724

Cash flow Firm U Firm Lto stockholders 700 644to bondholders 0 80Total 700 724

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• $80*30%=24: This tax saving is called interest tax shield

• The value of tax shield is

• present value of the interest tax shield =

• M&M proposition I with tax

• Suppose , which we call is as the unlevered cost of capital.

3001000*3.008.0

08.0*1000*03

08.0

24PV

DTRRDT CDDC ***

DTVV CUL *

7000

1.0

7001*

U

CU R

TEBITV

73001000*3.07000* DTVV CUL

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• The analysis implies that, once we include taxes, the optimal capital structure is 100% debt.

DTVV CUL *

T c * D

V u

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M&M proposition II with tax

• Without debt, the WACC is 10%, and, with debt, the WACC is 9.6%. The firm is better off with debt.

E

TDRRRR C

DUUE

1

%22.10

6300

3.01100008.01.01.0

ER

CDE TRV

DR

V

EWACC 1

%6.93.01%87300

1000%22.10

7300

6300WACC

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Example:1.0R ,2.0R 500,D ,34.0T ,52.151 DUC EBIT

Q : W h a t i s t h e v a l u e o f e q u i t y ?W h a t i s t h e c o s t o f e q u i t y ?W h a t i s t h e W A C C ?

500

2.0

100

2.0

34.01*52.1511*

U

CU R

TEBITV

670500*34.0500* DTVV CUL

T h e v a l u e o f e q u i t y : 170500670 DVE L

F r o m M & M p r o p o s i t i o n I I , t h e c o s t o f e q u i t y :

E

TDRRRR C

DUUE

1

%4.39

170

34.015001.02.02.0

ER

T h e W A C C i s :

CDE TRV

DR

V

EWACC 1

%92.1434.01%10670

500%4.39

670

170WACC

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RE

WACCRD

D/E

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• Debt has tax benefit, but also has cost, bankruptcy cost.

• Bankruptcy costs:

• Direct bankruptcy cost

• Indirect bankruptcy cost

DTVV CUL *

b a n k r u p t c y c o s tT c * D t r u e f i r m v a l u e

V u

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RE

RuWACCRD

D/E