CF

473.32

13

Winter 2014

Corporate Finance

1 core idea

r ractivities funders>If then

Jargon Alert!

Financial Leverage “lots of debt”

Capital Structure “Debt/Equity ratio”

Financial Leverage

effect of financial leverage on cash flows cost of equity

impact of taxes and bankruptcy on capital structure choice

Capital Structure

D/E ratio How do we change it?

leverage issue debt buy outstanding shares

leverage issue new shares retire outstanding debt

Observed Capital Structures

differ by industry D/E ratio guide for

• lenders

• shareholders

• firm

Capital Structure

D/E ratio What happens if we change it?

D/E ratio Leverage rewardspunishments

Capital Structure

D/E ratio Leverage volatility

» EPS» ROE

interest expensetaxes

good yearsstock value

bad yearsstock value

Financial Leverage

suppose $8m assets 10% interest rate rational market $20 share price 0.2m0.4mshares

$4.0m-debt

$4.0m$8.0mequity

D/E=1no debt

economy

EBIT

good $1.5m

average $1.0m

bad $0.5m

no debt

ROE EPS

18.75% $3.75

12.50% $2.50

6.25% $1.25

D/E=1

interest ROE EPS

$0.4m 27.50% $5.50

“ 15.00% $3.00

“ 2.50% $0.50

ignore taxes (for now)

Choosing a Capital Structure

goal: maximize stockholder wealth

2 methods• maximize firm value

or • minimize WACC

Financial Leverage

What is best amount? use “break-even EBIT” as reference point

• where EPS same for both amounts of debt

• if we expect EBIT > break-even point then leverage beneficial our stockholders

• if we expect EBIT < break-even point then leverage detrimental to stockholders

Financial Leverageno

debtD/

E=1

a b

interest i - $0.4m

# shares s 0.4m 0.2m

ba EPSEPS

s

iEBITEPS

b

bb

a

aa

s

iEBIT

s

iEBIT

ab

ab is

siEBITEBIT

break-even EBIT:

Modigliani & Miller

Theory of Capital Structure Proposition I: v firm value

Proposition II: WACC

M&M

v determined by: cash flows risk of assets

change v by: change cash flows change risk of cash flows

M&M

Case I: No Taxes

No Bankruptcy Costs

Proposition I• v NOT affected by changes in capital structure

• cash flows don’t change, so v doesn’t change

Proposition II• WACC NOT affected by changes in cap structure

M&M

Case I: No Taxes

No Bankruptcy Costs

M&M

Case II: with Taxes

No Bankruptcy Costs

interest tax deductible• so:

debt

taxescash

v

M&M

Case II: with Taxes

No Bankruptcy Costs

Proposition I• v IS affected by changes in capital structure

• cash flows change, so v changes

Proposition II• WACC IS affected by changes in cap structure

M&M

Case II: with Taxes

No Bankruptcy Costs

Proposition I

Proposition II

shieldax interest tPVv

shieldax interest tPVvv ul

dul vtvv c

cel

dldeueu t

v

vrrrWACC

1

M&M

Case II: with Taxes

No Bankruptcy Costs

M&M

Case II: with Taxes

No Bankruptcy Costs

M&M

Case III: with Taxes

with Bankruptcy Costs risks

• to shareholders

• to bondholders

constraint on debt financing legal & administrative problems

• management focus lost

• lost sales

• interrupted operations

• loss of valuable employees

M&M

Case III: with Taxes

with Bankruptcy Costs

interest still tax deductible bankruptcy risks

debt

chance of bankruptcy riskWACC

M&M

Case III: with Taxes

with Bankruptcy Costs

Proposition I• v increases initially due to tax benefit of debt

until overwhelmed by bankruptcy risk

Proposition II• WACC

declines at moderate debt level increases at high debt level

M&M

Case III Proposition 1

M&M

Case III Proposition 2