corporate finance-ii emba winter semester 2009 lahore school of economics

Corporate Finance-IICorporate Finance-II

EMBAEMBAWinter Semester 2009Winter Semester 2009

Lahore School of EconomicsLahore School of Economics

Chapter-17Chapter-17

Financial leverage & Capital Financial leverage & Capital structure policystructure policy

Financial leverage & Capital structure policyFinancial leverage & Capital structure policy

Learning Objectives

Capital structure?

Effect of Financial Leverage?

M&M Propositions?

Corporate Taxes & Capital Structure?

Optimal Capital Structure?

Bankruptcy Process & Costs?

The Capital StructureQuestion

What is it?….

How much Debt relative to Equity should a firm have?

What should be the Borrowing policy?

Capital Structure

Restructuring..

If a firm wants to increase D/E ratio (increase borrowing) What could it do…? (keeping its assets same)

Capital Structure

Restructuring..

If a firm wants to increase D/E ratio (increase borrowing) What could it do…? (keeping its assets same)

Issue Bonds & use the cash proceeds to buy Shares!

Capital Structure

Restructuring..

If a firm wants to decrease D/E ratio (reduce borrowing) What could it do…? (keeping its assets same)

Capital Structure

Restructuring..

If a firm wants to decrease D/E ratio (reduce borrowing) What could it do…? (keeping its assets same)

Issue Stock & use the cash to pay off Debt!

Firm value & Stock Value – An Example

The Market value of JJ Sprint company is $1000. The company currently has no debt, & JJ Sprint’s 100 shares sell for $10 each. Further suppose that JJ Sprint restructures itself by borrowing $500 & then paying out the proceeds to shareholders as an extra dividend of $5 per share.

Firm value & Stock Value – An Example

Debt plus Dividend

No Debt I II III

Debt $0 $500 $500 $500

Equity 1000 750 500 250

Firm Value

1000 1250 1000 750Debt plus Dividend

I II III

Equity Value reduction

-250 -500 -750

Dividends 500 +500 500

Net Effect +250

0 -250

Firm Value & Stock ValueThis means..

Change in the value of the firm is the same as the net effect on the stockholders.

Financial Managers can try to find the Capital structure that maximizes the value of the firm

Capital Structure

How should the firm approach this decision?..

Maximization of shareholder value

Maximization of Share price

Same as:

Maximizing the whole value of the Firm!

Capital Structure & The cost of Capital

Alternatively:

Firm should focus on Minimizing WACC. As, WACC is the appropriate discount rate for the firm’s overall Cash flows. Because values & discount rates move in opposite directions:

Minimizing WACC should result in:

Maximizing Value!

Capital Structure & The cost of Capital

And so..

Optimal Capital Structure (D/E ratio) represents lowest

possible WACC

Also called: TARGET Capital Structure

The effect of financial leverage

Effects of Financial Leverage?..

Financial Leverage refers to the extent to which a firm relies on Debt.

More Debt means MORE leverage

THE Effects of Financial Leverage - Example

We consider case of company X which has no debt & is considering restructuring to include debt in its capital structure.

We look at DEBT & NO DEBT situations

Taxes are ignored


Current Proposed

Assets $8,000,000 $8,000,000

Debt 0 4,000,000

Equity 8,000,000 4,000,000

Debt-Equity Ratio

0 1

Share Price 20 20

# of Shares 400,000 200,000

Interest Rate 10% 10%


Current Capital Structure: No DebtRecession Normal Expansion

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

Interest ? ? ?

Net Income ? ? ?

ROE ? ? ?

EPS ? ? ?


Current Capital Structure: No DebtRecession Normal Expansion

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

Interest 0 0 0

Net Income 500,000 1,000,000 1,500,000

ROE 6.25% 12.5% 18.75%

EPS 1.25 2.50 3.75


Current Capital Structure: Debt - $4 Million

Recession Normal Expansion

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

Interest ? ? ?

Net Income ? ? ?

ROE ? ? ?

EPS ? ? ?


Current Capital Structure: Debt - $4 Million

Recession Normal Expansion

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

Interest 400,000 400,000 400,000

Net Income 100,000 600,000 1,100,000

ROE 2.50% 15.50% 27.50%

EPS 0.50 3.00 5.50

Leverage & EPS

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

Recession Expected Expansion

EPS No Debt EPS Debt


Leverage & ROE

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%


ROE No Debt ROE w /Debt


Leverage & Net Income

$0$200,000$400,000$600,000$800,000

$1,000,000$1,200,000$1,400,000$1,600,000


Net Income No Debt Net Income w/Debt


EPS & EBIT Slopes (Leverage)

-3

-2

-1

0

1

2

3

4

5

0 400000 800000 1200000

EBIT

EP

S

EPS No debt EPS w /debt

Debt disadvantage

Debt Advantage

EPS Becomes sensitive to Leverage


Finding the BE point..

With NO Debt…

EPS = EBIT/400,000 shares

With DEBT

EPS = (EBIT-$400,000 / 200,000 shares)

Break even point is the point where EBIT is such that EPS under both scenarios is same:

Break Even EBIT = ?


Finding the BE point..

With NO Debt:

EPS = EBIT/400,000 shares

With DEBT:

EPS = (EBIT-$400,000 / 200,000 shares)

Break even point is the point where EBIT is such that EPS under both scenarios is same:

EBIT = 800,000 & EPS = $2

This is the indifference point

Capital Structure & Break Even Point

Leverage is …

Beneficial if EBIT is ABOVE Break-even EBIT

&

Not beneficial if EBIT is BELOW Break-even EBIT

Capital Structure & Break-even point - Example

Suppose ABL has decided to increase its D/E ratio. It wants to increase Debt from Rs 1,500,000 to 10,000,000. The interest rate on this will be 16%. ABL has 750,000 shares outstanding which sell for Rs 85. If the restructuring increases the ROE. Calculate the indifference point or BE point for ABL!


Step 1: Calculate Interest Expense under both scenarios:

Interest expense current capital structure:= Debt * Interest Rate= 1500000*0.16 = 240000

Interest Expense NEW Capital Structure:= Debt * Interest Rate = 10000000 x .16 = 1600000


Step 2: Calculate No. of shares outstanding under both scenarios

Total # of shares under Current Capital structure = 750,000

# of shares repurchased under New Capital structure:= Increase in Debt / Price per share= (10M – 1.5M)/85= 100,000

Total # of shares outstanding under new capital structure= Already Outstanding Shares – Shares Repurchased= 750,000 – 100,000= 650,000

Step 3: Getting Break-even EBIT

Break-even point is the point where EPS under both scenarios is equal:

EPS WITH Current Capital Structure:

= (EBIT – 240,000)/750,000

EPS with NEW capital Structure:

= (EBIT – 1.6mm)/650,000


Step 3: Getting Break-even EBIT

Break-even point is the point where EPS under both scenarios is equal:

Break-even EBIT:

(EBIT-240000)/750,000 = (EBIT – 1.6M)/650,000

EBIT – 1.6M = 650000/750000 x (EBIT – 240000)

EBIT – 1.6M = (0.866 EBIT) – 207840

0.134 EBIT = 1.6M – 207840

EBIT = 10,389,254


Verifying EPS:

If EBIT is 10,389,254 then using equations we get:

No Debt: EPS = (10389254 - 240000)/750,000 = 13.53

Debt: EPS = (10389254 – 1.6M)/650,000 = 13.52


Capital Structure

Leverage Conclusions..

Capital Structure

Leverage Conclusions..

1. Effect of Leverage depends on EBIT.When EBIT is high, leverage is beneficial

2. Leverage increases returns (indicated by ROE & EPS)

3. Risk increases with Leverage (variability of ER’s)

Corporate Borrowing & Home Made Leverage

Home Made Leverage: The use of personal borrowings to change the overall amount of financial leverage to which the individual is exposed.

Home Made Leverage - Example

Proposed Capital Structure


EPS 0.50 3.00 5.50

Earnings for 100 shares

50 300 550

Net Cost = 100 shares * $20 = $2000

Original Capital Structure & home made Leverage

EPS 1.25 2.50 3.75

Earnings for 200 shares

250 500 750

Less: Interest @ 10% 200 200 200

Net Cost = (200 shares *20) – Amount Borrowed = 2000

Corporate Borrowing & Home Made Leverage

1. Home Made Leverage simply means, the investors can replicate the firm’s capital structure by using the same D/E ratio’s.

2. And investors can adjust their D/E to get different payoffs.

Thus, this implies…

The firm’s choice of capital structure does not matter!

Therefore,

The stock price should not be affected by capital structure, although the payoff’s do.

ASSIGNEMENT # 4 (5Quetsions)Q1: XYZ Corp has no debt outstanding & a total Market Value of

$150,000, EBIT is projected to be $15,000, if economic conditions are normal. If there is strong Expansion in the economy, then EBIT will be 30% higher. If there is recession, then EBIT will be 60% lower. XYZ is considering a $60,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2500 shares of stock 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 change in EPS when the economy expands or enters a recession.

B) Repeat Part (a) assuming that XYZ goes through with re-capitalization. What do you observe?

Q#1 (Continued)

C) Repeat part (a) & (b) assuming XYZ Corp has a tax rate of 35%.

D) Suppose XYZ Corp has a Market to Book ratio of 1. Calculate ROE under each of the three economic scenarios before any debt is issued. Also, calculate percentage change in ROE for economic Expansions & Recession assuming No taxes.

E) Repeat Part (D) assuming the firm goes through recapitalization.

F) Repeat part (D) & (E) assuming the firm has a tax rate of 35%.

Q#2 Break – EVEN EBIT

Malang Fabric Manufacturing is comparing two different capital structures, an all equity plan (Plan I) & a levered plan (Plan II). Under Plan I, Malang would have 150,000 shares of stock outstanding. Under Plan II there would be 60,000 shares of stock outstanding & 15 million Rupees in Debt outstanding. The interest rate on debt is 10% and there are no taxes.

A) If EBIT is 2million Rupees which plan will result in the higher EPS?

B) If EBIT is 7million Rupees, which plan will result in the higher EPS?

C) What is the Break – Even EBIT?

Q#3Break – Even EBIT with Taxes

Shantou Beverage is comparing two different capital structures. Plan I would result in 1,100 shares of stock outstanding 17 million yaun in Debt. Plan II would result in 900 shares of stock & 28 million yaun in Debt. Interest rate is 10%.

A) Ignoring taxes, compare both these plans to an all equity plan assuming that EBIT will be 10 million yaun. The all – Equity plan would result in 1,400 shares of stock outstanding. Which of these plans has the Highest EPS? The lowest?

Q#3 Continued

B) In part (A), what are the Break – even levels of EBIT for each plan as compared to that for all – equity plan? Is one higher than the other?

C) Ignoring taxes, when will EPS be identical for Plans I & II.

D) Repeat Parts (A), (B) & (C) assuming that the corporate tax rate is 40%.

Q#4 Home Made Leverage

Valencia Items, a prominent consumer products firm is debating whether or not to convert its all equity capital structure to one that is 40% debt. Currently, there are 2,000 shares outstanding and the price per share is 70 Euros. EBIT is expected to remain at 16,000 Euros per year forever. The interest rate on new debt is 10% & there are no Taxes.

A)Ms. Aznar, a shareholder of the firm owned 100 shares of stock. What is her Cash flow under the current capital structure? Assume that she keeps all 100 of her shares.

Q#4 Continued

B)Suppose Valencia does convert, but Ms Aznar prefers the current all Equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure.

C)Suppose Valencia does not convert, but Ms Aznar prefers a capital Structure that is 70% Debt. Show how she could lever her shares of stock to recreate the original capital Structure.

Q#5 Home Made leverage

ABC Co. & 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 & perpetual Debt; its stock is worth $400,000 & the interest rate on its debt is 9%. Both firms expect EBIT to be $75,000. Ignore Taxes.

A)Maichin owns $30,000 worth of XYZ’s stock. What rate of return is she expecting?

B)Show how Maichin could generate exactly the same cash flows & rate of return by investing in ABC & using home Made leverage.


Learning Objectives

Capital structure?


M&M Propositions?




Capital Structure & the cost of Equity Capital

M&M Proposition I with no Taxes

What we have just discovered regarding Capital Structure & the firm’s value through home-made leverage is proposed by Franco & Merton as the M&M proposition I which states:

The Value of the Firm is Independent of its capital structure

Or

It is irrelevant how a firm chooses its financing

M&M Pie

Stocks, 30%

Bonds, 70%

Stocks Bonds

M&M Pie

Stocks,

70%

Bonds,

30%Stocks

Bonds

M&M Proposition I-The Pie Model

M&M Proposition II with no taxes

Although Firm’s value may not change,

D/E is certainly affected…

The cost of Equity & Financial Leverage

M&M Proposition II with no taxes WACC = (E/V) x Re + (D/V) x Rd

If we re-arrange for cost of equity –Re- we get:

Re = WACC + (WACC-Rd)*(D/E)Or

Re = Ra + (Ra-Rd)*(D/E) (Ra = WACC)

This is M&M Proposition II!



M&M Proposition II with no taxes


It says cost of Equity depends on 3 things:

Ra = required return on Firm’s assets

Rd = Firm’s cost of Debt

D/E = Firm’s debt/equity ratio

RequiredReturn

WACC

D/E (debt to equity ratio)

Rd (cost of debt)

Ra

Re (cost of equity)r + (r -

rd)D/E

Cost of equity & wacc: m&m Proposition I & II WITHOUT taxes


M&M Proposition II without Taxes

Point to Note:

WACC does not depend on the D/E ratio

Another way to look at M&M II is:

The firm’s overall Cost of Capital (WACC) is unaffected by its Capital Structure

As debt increases, cost of equity also increases to offset lower debt cost!

So the WACC stays the same!

Capital markets are perfect•Markets are frictionless. •Perfect competition in product and securities markets. •Information efficiency. •Agents are perfectly rational and maximize utility.

There are no costs to bankruptcyAll cash flow streams are perpetuities and no growth is allowed. Managers always maximize shareholders’ wealth •(imply no agency costs) Homemade leverage is a perfect substitute

Assumptions used in M&M II

M&M Proposition without taxes -Evidence on Capital Structure

1) More profitable firms tend to use less leverage.

2) High-growth firms borrow less than mature firms do.

3) Firms’ asset base influence capital structure choice.

4) Stock market generally views leverage-increasing events positively.

5) Tax deductibility of interest gives firms an incentive to use debt.

M&M II Without Taxes - Example

Company X has WACC of 12%. It can borrow at 8%. If X chooses a capital structure of 80% Equity & 20% debt. Calculate the cost of equity?

If X changes to 50% equity & 50% debt, what is cost of equity?

What happens to WACC given different Capital Structures?

M&M II WITHOUT Taxes- Example

Company X has WACC of 12%. It can borrow at 8%. If X chooses a capital structure of 80% Equity & 20% debt. Calculate the cost of equity?

Step 1: Get cost of equity, ReRe = Ra + (Ra-Rd)*(D/E)

= 12% + (12-8%)*(.25)= 13%

M&M II WITHOUT TAXES- Example

Company X has WACC of 12%. It can borrow at 8%. If X chooses a capital structure of 80% Equity & 20% debt.

If X changes to 50% equity & 50% debt, what is cost of equity?

Re = Ra + (Ra-Rd)*(D/E) = 12% + (12-8)*(1)

= 16%

M&M II WITHOUT TAXES- Example

Company X has WACC of 12%. It can borrow at 8%. If X chooses a capital structure of 80% Equity & 20% debt. What happens to WACC given different Capital Structures?

Step 2: Get WACC for both cases (80/20 & 50/50)WACC (80/20) = (.8*13%) + (.2*8%)

= 12%

WACC (50/50) = (.5*16%) + (.5*8%)= 12%

NOTE: WACC does not change with change in Capital Structure!

Total systematic risk of firm’s equity has two parts:

Business Risk

Equity risk which comes from the nature of firm’s operating activities

Financial Risk

Equity risk which comes from the capital structure choice

M&M Proposition II –Business & Financial Risk

M&M Proposition II –Business & Financial RiskAccording to M&M II with No Taxes, there are two types of Risks inherent in cost of equity:

Business Risk

Depends on the nature of the business & is compensated through Ra (WACC)

Financial Risk

Depends on debt financing & is compensated through

[(Ra – Rd)*D/E] - zero for all equity company

Point to Note:

A Firm’s Cost of Equity increases as debt increases

…purely because of financial risk portion–

NOT business risk

M&M Proposition II –Business & Financial Risk


Learning Objectives

Capital structure?


M&M Propositions?




Features of Debt:

1. Interest is tax deductible (good)

2. Failure to pay debt causes bankruptcy (not good)

We look at taxes first…

M&M Proposition I & II WITH CORPORATE TAXES

We look at 2 firms…

Firm E (equity) & D (debt)

1. Same LHS of balance sheet = same assets

2. D has issued $1000 worth of perpetual Bonds at 8%

3. Interest bill is $80 per year forever

4. Tax rate is 30%

M&M Proposition I & II WITH CORPORATE TAXES – Example


Firm E Firm D

EBIT 1,000 1,000

Interest 0 80

EBT 1000 960

Taxes (30%) 300 276

Net Income 700 644


Cash flow from Assets Firm E Firm D

EBIT $1,000 $1,000

Taxes 300 276

Total 700 724


Cash flow Firm E Firm D

To Stockholders

$700 $644

To Bondholders

0 80

Total 700 724


We Observe…

Debt firm D will earn $24 extra every year.

This means…

Debt firm’s value is more than E by PV of $24 Perpetuity

So.. Risk of this additional $24?

Since this Tax shield is derived from interest, therefore, the risk is same as that of debt…

Which means, it’s discount rate is same 8% as debt.

M&M Proposition I & Taxes

Value of Tax Shield…

PV of tax shield = PV of Tax Benefit (Perpetuity):

PV of tax shield = 24/ .08

= (.30 * 1000 *.08)/.08

= (0.30*1000)

= 300

PV of interest tax shield = (T*D*Rd) / Rd

= T * D


M&M Proposition I & Corporate Taxes

Putting it together…

We have seen,

Value of Firm D (Vd) > value of Firm E (Ve) by PV of Tax shield

In other words…

Vd = Ve + (T*D)

Lets look at an interpretation…

Total Debt

Value No Debt

Value of firm with DebtVd = Ve+

(T*D)

M&M I with taxesFirm’s value increases with Debt due to Interest Tax

Shield (slope = T)

Ve=value w/no debt

Valu

e o

f th

e

firm

This means…

Value of Firm goes UP by the tax rate T..

For every $1 additional Debt, Value of Firm increases by $0.3

Or

The NPV per dollar of Debt is $0.3

Therefore:

Higher debt results in lower WACC (since the Mkt value is higher)

M&M PROPOSITION I with taxes


Firm E Firm D

EBIT 1,000 1,000

Interest 0 80

EBT 1000 960

Taxes (30%) 300 276

Net Income 700 644


Suppose that cost of capital (Unlevered) for Firm E is 10%. Firm E’s cash flows is $700 every year forever & since it has no debt then, appropriate Discount Rate is 10%. Then,

Value of Firm E = NI / Ra= 700/ 0.10= 7,000

Value of Firm D = ?


Suppose that cost of capital (Unlevered) for Firm E is 10%. Firm E’s cash flows is $700 every year forever & since it has no debt then, appropriate Discount Rate is 10%. Then,

Value of Firm E = NI / Ra= 700/ 0.10= 7,000

Value of Firm D = Vu + (T*D)= 7,000 +( 0.30*1000)= 7,300

M&M PROPOSITION I with taxes

Conclusion:

Debt Increases Value of Firm due to Tax shield!

So….

The more Debt, the better

A Firm should maximize borrowing

M&M II with corporate Taxes - Preview

M&M Proposition II without Taxes:

WACC = (E/V) x Re + (D/V) x Rd


If, we introduce taxes, then?

M&M II with corporate Taxes - Preview

M&M Proposition II without Taxes:

WACC = (E/V) x Re + (D/V) x Rd

Re = Ra + (Ra-Rd)*(D/E)

(Ra = WACC for unlevered firm)

If, we introduce taxes, then:

WACC = (E/V) x Re + (D/V)*Rd*(1-T)

Re = Ra + (Ra – Rd)*(1-T)*(D/E)

(Ra = WACC for unlevered firm)

We look at 2 firms…

Firm E (equity) & D (debt)

1. Same LHS of balance sheet = same assets

2. D has issued $1000 worth of perpetual Bonds at 8%

3. Interest bill is $80 per year forever

4. Tax rate is 30%, Cost of Capital for Firm E = 10%

5. Value of Firm E = 7,000 & Value of Firm D = 7,300

6. Re for Firm L = ?

7. WACC for Firm L = ?

M&M Proposition II WITH CORPORATE TAXES – Example

M&M Proposition II WITH CORPORATE TAXES – Example

ReL = Ra + (Ra – Rd)*(1-T)*(D/E)

= 10% + (10 – 8%)*(1-0.30)*(1000/6300)= 10.22%

WACCL

= [(E/V) *Re] + [(D/V)*Rd*(1-T)]= [(6300/7300)*10.22%] + [(1000/7300)*8*(0.70)]= 9.6%

M&M Proposition II WITH CORPORATE TAXES

Ra = 10%

Re

WACC

Rd*(1-t)

Re = 10.22%

WACC = 9.6%

Rd = 5.6%

D/E = 1000/6,300

Debt-Equity Ratio


You are given following information about XYZ co. :EBIT = $151.52T = 0.34D = 500Ru = 0.20

The cost of debt capital is 10%. What is the value of XYZ’s Equity? What is the cost of Equity Capital for XYZ? What is the WACC?


Step 1: Calculate Value of the firm if it had NO Debt:Vu = EBIT(1 – T) / Ru

= $500

Step 2: Calculate Value of the Firm with Debt:VL = Vu + (T*D)

= 500 + (0.34*500)= 670


Step 3: Calculate Value of Equity:E = VL – D

= 670 – 500= 170

Step 4: Calculate Cost of Equity:ReL = Ra + (Ra – Rd)*(1-T)*(D/E)

= 0.2 + (0.2 – 0.1)*(1-0.34)*(500/170)= 39.4%


Step 5: Calculate WACCWACC = (E/V) x Re + (D/V)*Rd*(1-T)= [(170/670)*39.4%] + [(500/670)*10%*(1-0.34)]= 14.92%

What is Bankruptcy?…

Bankruptcy Costs

What is Bankruptcy?…

As the Debt-Equity Ratio rises, so too does the probability that the firm will be unable to pay its bondholders what was promised to them.

When this happens, ownership of the firm’s Asset is ultimately transferred from the stock holders to Bondholders.

A firm becomes Bankrupt when the Value of its Assets equal the Value of its Debt.

Bankruptcy Costs

Stockholders: try to avoid bankruptcy while in control

Bondholders: want bankruptcy to get their money

This makes both groups fight…

Disrupting operations of the business & reducing the value of sales & assets!

Bankruptcy Costs - drivers

Three types of Bankruptcy Costs…

Direct bankruptcy costs

Indirect bankruptcy costs

Bankruptcy Costs

Direct bankruptcy costs…

When value of Assets = Debt

Means…

Equity = 0, and firm is economically bankrupt!

The administrative costs associated with the legal process of turning assets to bondholders

Bankruptcy Costs – Direct Bankruptcy Costs

Indirect bankruptcy costs…

When a firm has significant problems in meeting debt obligations, it is in financial distress

The costs associated with AVOIDING a bankruptcy filing.

NOTE: Costs associated with bankruptcy exceed tax-related gains from leverage

Bankruptcy Costs – Indirect Bankruptcy Costs

Good Points (Low D/E)

Tax shield adds value

Probability of Bankruptcy is low

Benefit of Debt outweighs costs (at low D/E)

Bad points (High D/E)

Possibility of financial distress increased

Benefit of Debt offset by Financial distress costs!

Optimal Cap Structure obviously is b/w these 2 extremes

Optimal Capital Structure

corporate finance-ii emba winter semester 2009 lahore school of economics

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