17-0 week 10 lecture 10 ross, westerfield and jordan 7e chapter 17 financial leverage and capital...
TRANSCRIPT
17-1
Week 10
Lecture 10
Ross, Westerfield and Jordan 7e
Chapter 17
Financial Leverage and
Capital Structure Policy
17-2
Last Lecture..
• Cost of Equity• Cost of Preferred Stock• Cost of Debt• Proportion or weight of each form of
financing• Cost of Capital = WACC
• Unadjusted/Adjusted• When should we use WACC?• Other approaches: pure play and subjective
• Flotation Costs
17-3
Chapter 17 Outline
• The Capital Structure Question
• The Effect of Financial Leverage
• Capital Structure and the Cost of Equity Capital
• M&M Propositions I and II with Corporate Taxes
• Bankruptcy Costs
• Optimal Capital Structure
17-4
Choosing a Capital Structure
• What is the primary goal of financial managers?• Maximize stockholder wealth
• Choose the optimal capital structure
• Maximize the value of the firm
• Minimize the WACC
17-5
Capital Restructuring
• Financial leverage = the extent to which a firm relies on debt financing
• 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
17-6
The Effect of Leverage
• How does leverage affect the EPS and ROE of a firm?
• More debt financing, means more fixed interest expense
• In expansion, we have more income after we pay interest, have more left over for stockholders
• In recession, we still have to pay our costs therefore we have less left over for stockholders
• Leverage amplifies the variation in both EPS and ROE
17-7
Example: Financial Leverage, EPS and ROE
17-8
Break-Even EBIT
• Break-Even EBIT where:
EPS debt = EPS no debt
• If expected EBIT > break-even EBIT, then
leverage is beneficial to our stockholders
• If expected EBIT < break-even EBIT, then
leverage is detrimental to our stockholders
17-9
Example: Break-Even EBIT
$500250
$125000 EBIT
125000250EBIT
125000500EBIT250EBIT
250EBIT500250EBIT250
250EBIT
500
EBIT
EPSEPS
shares
interestearnings
shares
earningsdebtdebt no
Break-even GraphEPS with No Debt = $500/500 = $1
EPS with Debt = ($500-$250)/250 = $1
Numbers in thousands
17-10
Break Even EBIT
With debt
With no debt
17-11
Capital Structure Theory
• Modigliani and Miller Theory of Capital Structure• Proposition I – firm value• Proposition II – cost of equity & 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
17-12
Capital Structure Theory Under Three Special Cases
• Case I – Assumptions• No taxes• No bankruptcy costs
• Case II – Assumptions• With taxes• No bankruptcy costs
• Case III – Assumptions• With taxes• With bankruptcy costs
17-13
Case I – No Taxes
• 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• Cost of Equity increases as Debt increases• The WACC of the firm is NOT affected by
capital structure
17-14
Case I - No Taxes - 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
17-15
Figure 17.3
17-16
Case I - No Taxes - Example
• Data• Required return on assets = WACC = RA = 16%,• Cost of debt = RD = 10%• Percent of debt = D = 45%• E = 1 - 0.45 = 0.55 or 55%• D/E = 0.45/0.55 = 0.82
• What is the cost of equity?• RE = RA + (RA – RD)(D/E)
• RE = 0.16 + (0.16 – 0.10)(.45/.55) = 20.91%
• Proof for WACC:• WACC = RA = (E/V)RE + (D/V)RD
• WACC = RA = 0.55 * 20.91% + 0.45 * 10% = 16%
17-17
Case I – No Taxes Example continued..
• What happens if the firm increases leverage so that D/E = 1.5? (before D/E = 0.82 when D=45%,E=55%)
• What is the cost of equity? • RE = RA + (RA – RD)(D/E)
• RE = 0.16 + (0.16 – 0.10)(1.5) = 0.25 or 25%
• Proof for WACC:• WACC = RA = (E/V)RE + (D/V)RD
• From D/E = 1.5, D = 60%, E = 40%
• WACC = 0.4 * 25% + 0.6 * 10% = 16%
D/E1
1
V
E
17-18
The CAPM, Business Risk, Financial Risk and Proposition II
• How does financial leverage affect systematic risk?
• CAPM: RE = Rf + E(RM – Rf) – for equity
• CAPM: RA = Rf + A(RM – Rf) – for assets
• Where A is the firm’s asset beta and measures the systematic risk of the firm’s
assets, also called unleverred beta – the risk of the assets if the firm would have no debt ( in essence E = A if no debt)
• RE = RA + (RA – RD)(D/E)
• RE = RA + (RA – Rf)(D/E) - assume RD = Rf
• Proposition II• As we introduce debt in the firm:
• RE = Rf + A(1+D/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)
17-19
Case II – Introducing Taxes
• What happens to the firm’s cash flows?• 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?
17-20
Case II - with Taxes - Example
Unlevered FirmNo Debt
Levered FirmWith Debt
EBIT 5000 5000
Interest 0 (6250@8%) 500
Taxable Income
5000 4500
Taxes (34%) 1700 1530
Net Income 3300 2970
CFFA 3300 3470
17-21
Interest Tax Shield
• Annual interest tax shield• Tax rate times interest payment• 6250 in 8% debt = 500 in interest expense• Annual tax shield = 0.34(500) = 170
• Present value of annual interest tax shield• Assume perpetual debt for simplicity• PV = 170 / 0.08 = 2125
CD
CD TDR
TRDPV
21250.3462500.08
0.340.086250PV
17-22
Case II - with Taxes - 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• Assuming perpetual cash flows
• VU = EBIT(1-T) / RU
with no debt RU = RA= RE and VU = E
• VL = VU + D*TC
• E = VL - D
17-23
Case II – with TaxesProposition I - Example
• Data Inc. has earnings of 25 million per year every year. The firm has no debt and the cost of capital is 12%. If tax is 35% what is the value of the firm?• EBIT = 25 million; Tax rate = TC= 35%;
Unlevered cost of capital = RU= 12% = RA = RE
VU = ?
• VU = EBIT(1-T) / RU
• VU = 25(1-0.35) / 0.12 = $135.42 million
• VU = E
17-24
Case II – with TaxesProposition I - Example (cont.)
• Data Inc. decides to issue bonds that have a market value of 75 million at a cost of 9%. What is the value of the firm? What will be the value of equity?• D = $75 million, RD= 9%, VL = ?, E = ?
VU = 135.42 (calculated on previous slide)
• VL = VU + tax shield
• VL = VU + D*TC
• VL = 135.42 + 75(0.35) = $161.67 million
• E = VL - D• E = 161.67 – 75 = $86.67 million
17-25
Figure 17.4 Case II - with Taxes Proposition I
17-26
Case II – with Taxes - Proposition II
• Recap: In case I – Proposition II - no taxes:• RE increases as Debt increases
• WACC is unchanged
• When taxes are introduced in Case II:• RE increases as Debt increases
RE = RU + (RU – RD)(D/E)(1-TC)
• WACC decreases as D/E increases because the cost of debt decreases
RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)
17-27
Case II – with Taxes Proposition II - Example
• Data Inc. info from Case II proposition I:• EBIT = 25 million; TC= 35%; D = $75 million;
RD= 9%; Unlevered cost of capital = RU= 12%
E = $86.67m; VL = $161.67mD/E = 75/86.67 = 0.87, E/V = 86.67/161.67 = 0.54,D/V = 75/161.67 = 0.46
• RE = RU + (RU – RD)(D/E)(1-TC)• RE = 0.12 + (0.12-0.09)(0.87)(1-0.35) = 13.69%
• RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)• RL = WACC = (0.54)(0.1369) + (0.46)(0.09)(1-.35) =
10.05%
17-28
Example: Case II – Proposition II
• Suppose Data Inc. changes its capital structure so that the debt-to-equity ratio becomes 1.• Before: D/E = 0.87, E= 54%, D=46%• Now: D/E = 1, E= 50%, D=50%
• What will happen to the cost of equity under the new capital structure? (previously 13.69%)
• RE = 0.12 + (0.12 – 0.09)(1)(1-0.35) = 13.95%
• What will happen to the weighted average cost of capital? (previously 10.05%)
• WACC = 0.5(0.1395) + 0.5(0.09)(1-0.35) = 9.9%
• What if D/E = 1.25?, RE = ?, WACC = ?
17-29
Figure 17.5 - Case II with Taxes Proposition II
17-30
Case III – with Bankruptcy Costs
• Now we add bankruptcy costs• As the D/E ratio increases, the probability of
bankruptcy increases• This increased probability will increase the
expected bankruptcy costs• At some point, the additional value of the interest
tax shield will be offset by the increase in 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
17-31
Figure 17.6 – Case III with Bankruptcy costs
17-32
Figure 17.7 Case III with Bankruptcy costs
17-33
Bankruptcy Costs
• Direct costs• Legal and administrative costs
• Indirect costs• Larger than direct costs & more difficult to
measure and estimate
• Financial distress costs• All costs associated with going bankrupt
and/or avoiding bankruptcy
17-34
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 just offsets the increase in expected bankruptcy costs
17-35
Figure 17.8
17-36
Managerial Recommendations
• The tax benefit is only important if the firm has a large tax liability
• Risk of financial distress• The greater the risk of financial distress, the
less debt will be optimal for the firm• The cost of financial distress varies across
firms and industries and as a manager you need to understand the cost for your industry
17-37
End Chapter 17