CHAPTER 16 Financial Leverage and Capital Structure Policy

CHAPTER 16

Financial Leverage and Capital Structure Policy

What is meant by capital restructuring

What is the primary goal of financial managers?

Can leverage help in achieving such goals?

Capital Restructuring

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

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

Choosing a Capital Structure

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

Financial Leverage

Financial leverage, EPS, and ROE: an example

proposed current

8,000,000 8,000,000 Asset

4,000,000 0 debt

4,000,000 8,000,000 Equity

1 0 Debt-equity ratio

20 20 Share price

200,000 400,000 Shares out standing

10% 10% Interest rate

Current capital structure : No Debt

expansion expected Recession

1,500,000 1,000,000 500,000 EBIT

0 0 0 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

1,500,000 1,000,000 500,000 EBIT

400,000 400,000 400,000 Interest

1,100,000 600,000 100,000 Net income

27.5% 15% 2.5% ROE

5.5 3 0.5$ EPS

Financial leverage, EPS, and ROE: an example

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

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

A. 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.

B. Repeat part (a) assuming that the economy goes with

recapitalization. What do you observe?

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.

A. If EBIT is 350,000$, which plan will result in the higher EPS?

B. If EBIT is 500,000$, which plan will result in the higher EPS?

C. What is the break-even EBIT?

Corporate borrowing & home made leverage

1. The effect of leverage depends on the company’s EBIT. When

EBIT is relatively high, leverage is beneficial

2. Under the expected scenarios, leverage increase the returns

to shareholders, as measured by both ROE and EPS

3. 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

4. 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

Homemade leverage: the use of personal

borrowing to change the overall amount of

financial leverage to which the individual is

exposed.



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 EPS

750 500 250 Earnings for 200 shares

200 200 200 Less: interest on $2,000 at 10%

550 300 50 Net earnings

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$

A. Rico owns 30,000$ worth of XYZ’s stock. What rate of

return is he expecting?

B. Show how Rico could generate exactly the same cash flows

and rate of return by investing in ABC and using homemade

leverage?

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)

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



Example

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?

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?

Firm L Firm U

1,000 1,000 EBIT

80 0 I

920 1,000 Taxable income

276 300 Taxes (30%)

644 700 NI


Firm L Firm U CFFA

1,ooo 1,ooo EBIT

276 300 Taxes

724 700 total


Firm L Firm U Cash flow

644 700 To stock holder

80 0 To bond holder

724 700 total

M & M proposition I with 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


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?

Proposition II with taxes

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?

Ex 11 Page 543

In the previous question suppose that corporate tax

rate is 35 percent. What is EBIT? What is the

WACC? Explain?

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?

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?

Bankruptcy Costs

Direct costs

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

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

Bankruptcy Costs

Optimal Capital Structure

The static theory of capital structure:

Optimal Capital Structure and the cost of capital

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

Managerial recommendations

Taxes

Financial distress

Documents

CHAPTER 16 Financial Leverage and Capital Structure Policy