FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY

Chapter 16

16-2

Quiz on WACCCompany’s D/E ratio is 2/3, they

need 5500 financing and they want to keep the same D/E ratio. How much equity they should issue? (1p.)

Company’s cost of equity is 14% and cost of debt is 8%, tax is 40%; D/E ratio is ¼. What is WACC? (2p).

16-3

Chapter OutlineThe Capital Structure DecisionThe Effect of Financial LeverageCapital Structure and the Cost of

Equity Miller&Modigliani PropositionsBankruptcy CostsOptimal Capital StructureExtended Pie ModelObserved Capital Structures

16-4

Capital RestructuringCapital restructuring involves

changing the amount of leverage a firm has without changing the firm’s assets

Increase leverage by issuing debt and repurchasing outstanding shares

Decrease leverage by issuing new shares and retiring outstanding debt

Financial leverage = the extent to which the firm relies on debt

16-5

Choosing a Capital StructureWhat is the primary goal of

financial managers?◦Maximize stockholder wealth

Stockholders’ wealth can be maximized by maximizing firm value or minimizing WACC

16-6

The Effect of LeverageHow 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

16-7

Financial Leverage, EPS and ROE, example (1)

Current capital structure: No debt Recession Expected Expansion

EBIT $500,000 $1,000,000$1,500,00

0Interest 0 0 0Net income 500,000 1,000,000 1,500,000ROE 6.25% 12.50% 18.75%EPS $1.25 $2.50 $3.75

Proposed capital structure: Debt = $ 4 mln Recession Expected Expansion

EBIT $500,000 $1,000,000$1,500,00

0Interest 400,000 400,000 400,000Net income 100,000 600,000 1,100,000ROE 2.50% 15.00% 27.50%EPS $0.50 $3.00 $5.50

16-8

Financial Leverage, EPS and ROE, example (2)

Variability in ROE◦Current: ROE ranges from 6.25% to

18.75%◦Proposed: ROE ranges from 2.50% to

27.50%Variability in EPS

◦Current: EPS ranges from $1.25 to $3.75

◦Proposed: EPS ranges from $0.50 to $5.50

The variability in both ROE and EPS increases when financial leverage is increased

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Degree of financial leverage

EBITinchangePercentage

EPSinchangePercentageleveragefinancialofDegree

InterestEBIT

EBITleveragefinancialofDegree

16-10

Break-Even EBITFind EBIT where EPS is the same

under both the current and proposed capital structures

If EBIT is expected to be greater than the break-even point, then leverage is beneficial to stockholders

If EBIT is expected to be less than the break-even point, then leverage is detrimental to stockholders

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Financial Leverage, EPS and ROEBreakeven (indifference) EBIT solution:

$2.00400,000

800,000EPS

$800,000EBIT

800,0002EBITEBIT

400,000EBIT200,000

400,000EBIT

200,000

400,000EBIT

400,000

EBIT

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Homemade Leverage and ROE

Current Capital Structure◦ Investor borrows $2000

and uses $2000 of their own to buy 200 shares of stock

◦ Payoffs: Recession: 200(1.25)

- .1(2000) = $50 Expected: 200(2.50)

- .1(2000) = $300 Expansion: 200(3.75)

- .1(2000) = $550◦ Mirrors the payoffs from

purchasing 100 shares from the firm under the proposed capital structure

Proposed Capital Structure◦ Investor buys $2000

worth of stock (100 shares)

◦ Payoffs: Recession:

100(0.50) = $50 Expected:

100(3.00) = $300 Expansion:

100(5.50)= $550

16-13

Homemade leverageThe use of personal borrowing to

change the overall amount of financial leverage to which individual is exposed

The investor can both “lever” his position through borrowing or “unlever” - through lending

16-14

Capital Structure TheoryModigliani and Miller Theory of

Capital Structure◦Proposition I – the pie model◦Proposition II – WACC

The value of the firm is determined by the cash flows to the firm and the risk of the assets

16-15

Capital Structure Theory Under Three Special Cases

Case I – Assumptions (M&M)◦No corporate or personal taxes◦No bankruptcy costs

Case II – Assumptions (M&M)◦Corporate taxes◦No bankruptcy costs

Case III – Assumptions (Static Theory)◦Corporate taxes◦Bankruptcy costs

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Case I – No Taxes or Bankruptcy Costs

M&M 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

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Case IWACC = RA = (E/V)RE + (D/V)RD

RE = RA + (RA – RD)(D/E)

◦RA is the required return on the firm’s assets

◦(RA – RD)(D/E) is the additional return required by stockholders to compensate for the risk of leverage

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Case I, exampleData

◦Required return on assets = 16%, cost of debt = 10%; percent of 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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The CAPM, the SML and Proposition II

CAPM: RA = Rf + A(RM – Rf)◦Where A is the firm’s asset beta and

measures the systematic risk of the firm’s assets

Proposition II◦RE = Rf + A(RM – Rf)(1+D/E)

16-20

Business Risk and Financial Risk

CAPM: RE = Rf + E(RM – Rf)◦E = A(1 + D/E)

Therefore, the systematic risk of the stock depends on:◦Systematic risk of the assets, A,

(Business risk)◦Level of leverage, D/E, (Financial risk)

RE = Rf + A(1+D/E)(RM – Rf)

Quiz – February 28Company A’s D/E=.6; the beta of

its assets is 1.2; expected market return is 13% and the risk free rate is 3%. What is the required return on company A’s equity?

If there are no taxes and RD = .08, what is the Company’s weighted average cost of capital?

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16-22

Case II – With Corporate Taxes

Interest is tax deductible

The reduction in taxes increases the cash flow of the firm

Interest tax shield = The tax saving attained by a firm from

interest expense

Case II, example (1)

Unlevered Firm

Levered Firm

EBIT 5000 5000

Interest 0 500

Taxable Income

5000 4500

Taxes 1700 1530

Net Income 3300 2970

CFFA 3300 3470

23

16-24

Case II, example (2)Assume the company has $6,250, 8%

coupon debt and faces a 34% tax rate.Annual interest tax shield

◦ Tax rate times interest payment:

◦ Annual tax shield = 170Present value of annual interest tax

shield:◦ PV = 170/.08

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Case II – Proposition IThe 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

◦Value of equity = Value of the firm – Value of debt

◦VU = EBIT(1-T) / RU

◦VL = VU + DTC

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Case II – Proposition I, example

◦EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%

VU =25*.65/.12=

VL

E=

16-27

Case II – Proposition IIThe WACC decreases as D/E

increases because of the government subsidy on interest payments◦WACC = (E/V)RE + (D/V)(RD)(1-TC)◦RE = RU + (RU – RD)(D/E)(1-TC)

Example◦RE = .12 + (.12-.09)(75/86.67)(1-.35) =

13.69%◦WACC = (86.67/161.67)(.1369) +

(75/161.67)(.09) (1-.35)WACC = 10.05%

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Case II – Proposition II, exampleSuppose that the firm changes its

capital structure so that the D/E ratio = 1.

What will happen to the cost of equity under the new capital structure?

What will happen to the weighted average cost of capital?

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Case III – with Bankruptcy Costs

As the D/E ratio increases, the probability of bankruptcy increases

At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy cost

At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added

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Bankruptcy Costs(Financial distress costs)Direct costs

◦Legal and administrative costs◦Ultimately cause bondholders to incur

additional losses◦Disincentive to debt financing

Indirect costs◦The difficulties of running business that

is experiencing financial distress◦Examples: potentially fruitful programs

are dropped, employees are leaving the company

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Static Theory of Capital StructureA 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

At this point the firm’s WACC is minimized

16-32

Static Theory and Firm Value

16-33

Extended Pie Model

16-34

The Value of the FirmValue of the firm = marketed claims +

non-marketed claims◦Marketed - claims of stockholders and

bondholders◦Non-marketed - claims of the government

and other potential stakeholdersThe overall value of the firm is

unaffected by changes in capital structure

The division of value between marketed claims and non-marketed claims may be impacted by capital structure decisions

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Observed Capital Structures

Capital structure differ by industry

There is a connection between different industry’s operating characteristics and capital structure

Firms and lenders look at the industry’s debt/equity ratio as a guide