leverage and capital structure chapter 13. key concepts and skills understand the effect of...

Leverage and capital structure

Chapter 13

Key concepts and skills

• Understand the effect of financial leverage on cash flows and cost of equity

• Understand the impact of taxes and bankruptcy on capital structure choice

• Understand the basic components of bankruptcy

13-2Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Chapter outline

• The capital structure question• The effect of financial leverage• Capital structure and the cost of equity capital• Corporate taxes and capital structure• Bankruptcy costs• Optimal capital structure• Observed capital structures• A quick look at the bankruptcy process

13-3 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Capital structure

• Capital structure—percentage of debt and equity used to fund the firm’s assets– ‘Leverage’ = use of debt in capital structure

• Capital restructuring—changing the amount of leverage 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


Capital structure and shareholder wealth

• What is the primary goal of financial managers?– To maximise shareholder wealth

• We want to choose the capital structure that will maximise shareholder wealth.

• We can maximise shareholder wealth by maximising firm value or minimising WACC.


The effect of financial leverage• How does leverage affect the earnings per share

(EPS) and return on equity (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, we pay our fixed

costs and we have more left over for our shareholders.

• If we have a really bad year, we still have to pay our fixed costs and we have less left over for our shareholders.

• Leverage amplifies the variation in both EPS and ROE.


Financial leverage, EPS and ROE example—Table 13.1

• We will ignore the effect of taxes at this stage.• What happens to EPS and ROE when we issue debt and buy back

shares?• Eagles Air Services


Table 13.1

Current ProposedAssets $8,000,000 $8,000,000Debt $0 $4,000,000Equity $8,000,000 $4,000,000Debt/Equity Ratio 0.0 1.0Share Price $20 $20Shares Outstanding 400,000 200,000Interest rate 10% 10%

Eagles Air ServicesCapital structure scenarios—Table 13.2


Table 13.2

Recession Expected ExpansionEBIT $500,000 $1,000,000 $1,500,000Interest 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

Current Capital Structure: No Debt

Recession Expected ExpansionEBIT $500,000 $1,000,000 $1,500,000Interest 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

Proposed Capital Structure: Debt = $4 million

Financial leverage, EPS and ROE—Example

• 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.


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 shareholders.

• If we expect EBIT to be less than the break-even point, then leverage is detrimental to our shareholders.


Break-even EBIT—ExampleEPS = for both capital structures


$2.00400,000

800,000EPS

$800,000EBIT

800,000EBIT2EBIT

400,000EBIT200,000

400,000EBIT

200,000

400,000EBIT

400,000

EBIT

Break-even EBIT (cont.)

• 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.


Eagle Air Services—Conclusion

1. The effect of leverage depends on EBIT:When EBIT is higher, leverage is beneficial.

2. Under the ‘expected’ scenario, leverage increases ROE and EPS.

3. Shareholders are exposed to more risk with more leverage.

ROE and EPS more sensitive to changes in EBIT.4. Capital structure is an important

consideration owing to the impact of financial leverage.


Homemade leverage and ROE—Example

• Homemade leverage– The use of personal borrowing to change the overall amount of financial

leverage to which the individual is exposed.

Conclusion:• Any stockholder who prefers leverage can create their own

‘homemade’ leverage and replicate the payoffs.• Eagle Air Services’ capital structure is irrelevant to shareholders.


Capital structure theory

• Modigliani and Miller – M&M Proposition I—The pie model– M&M Proposition II—WACC

• The value of the firm is determined by the cash flows to the firm and the risk of the firm’s assets.

• Changing firm value– Change the risk of the cash flows– Change the cash flows


Capital structure theory Three special cases

• Case I—Assumptions– No corporate or personal taxes– No bankruptcy costs

• Case II—Assumptions– Corporate taxes, but no personal taxes– No bankruptcy costs

• Case III—Assumptions– Corporate taxes, but no personal taxes– Bankruptcy costs


Case I—Propositions I and II

• 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.


Case I—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.


Case I—Example• Data

– Required return on assets = 16%, cost of debt = 10%, percentage of debt = 45%

• What is the cost of equity?– RE = .16 + (.16 - .10)(.45/.55) = .2091 = 20.91%

• Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio?

– .25 = .16 + (.16 - .10)(D/E)– D/E = (.25 - .16) / (.16 - .10) = 1.5

• Based on this information, what is the percentage of equity in the firm?

– E/V = 1 / 2.5 = 40%


M&M Propositions I and IIFigure 13.3

• The change in the capital structure weights (E/V and D/V) is exactly offset by the change in the cost of equity (RE), so the

WACC stays the same.


The CAPM, the SML and Proposition II

• How does financial leverage affect systematic risk?

• 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– Replace RA with the CAPM and assume that the

debt is riskless (RD = Rf).

– RE = Rf + A(1+D/E)(RM – Rf)


Business risk and financial risk

• RE = Rf + A(1+D/E)(RM – Rf)

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

• Therefore, the systematic risk of the share depends on:– Systematic risk of the assets, A (business risk)

– Level of leverage, D/E (financial risk)


Case II—Corporate taxes

• Interest on debt is tax deductible.• When a firm adds debt, it reduces taxes, all

else being equal.• The reduction in taxes increases the cash

flow of the firm.• The reduction in taxes reduces net income.


Case II—Example


Unlevered firm Levered firm

EBIT 5000 5000

Interest 0 500

Taxable Income 5000 4500

Taxes (30%) 1500 1350

Net Income 3500 3150

CFFA 3500 3650

Interest tax shield

• Annual interest tax shield– Tax rate times interest payment– 6250 in 8% debt = 500 in interest expense– Annual tax shield = .30(500) = 150

• Present value of annual interest tax shield– Assume perpetual debt for sake of simplicity– PV = 150 / .08 = 1875– PV = D(RD)(TC)/RD = DTC = 6250(.30) = 1875


Case II—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.– Value of equity = Value of the firm – Value of debt

• Assuming perpetual cash flows– VU = EBIT(1-T)/RU

– VL = VU + DTC


Case II—Proposition I (cont.)

• Data– EBIT = $25 million; tax rate = 30%; debt = $75

million; cost of debt = 9%; unlevered cost of capital = 12%

• VU = 25(1-.30) / .12 = $145.83 million

• VL = 145.83 + 75(.30) = $168.33 million

• E = 168.33 – 75 = $93.33 million


M&M Proposition I with taxesFigure 13.4


Case II—Proposition II

• The WACC decreases as D/E increases because of the government subsidy on interest payments.– RA = (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%– RA = (86.67/161.67)(.1369) + (75/161.67)(.09)

(1-.35)– RA = 10.05%


Case II—Proposition II (cont.)

• Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1.

• What will happen to the cost of equity under the new capital structure?– RE = .12 + (.12 - .09)(1)(1-.35) = 13.95%

• What will happen to the weighted average cost of capital?– RA = .5(.1395) + .5(.09)(1-.35) = 9.9%


Illustration of Proposition II


M&M summaryTable 13.4


M&M summaryTable 13.4 (cont.)


Bankruptcy costs

• Direct costs– Legal and administrative costs

• Enron = $1 billion; WorldCom = $600 million– Bondholders incur additional losses– Disincentive to debt financing

• Financial distress– Significant problems meeting debt obligations– Most firms that experience financial distress

do not ultimately file for bankruptcy


Indirect bankruptcy costs• Indirect bankruptcy costs

– Larger than direct costs, but more difficult to measure and estimate

– Stockholders wish to avoid a formal bankruptcy – 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

– Lost sales, interrupted operations, loss of valuable employees, low morale, inability to purchase goods on credit


Case IIIWith bankruptcy costs

• D/E ratio → probability of bankruptcy• probability → expected bankruptcy

costs• At some point, the additional value of the

interest tax shield will be offset by the expected bankruptcy costs.

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


Optimal capital structureFigure 13.5

13-37Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Conclusions• Case I—no taxes or bankruptcy costs

– No optimal capital structure• Case II—corporate taxes but no bankruptcy costs

– Optimal capital structure = 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


The capital structure questionFigure 13.6


Megan Maniscalco

Confirm or correct 'at some time' in Case V in the notes pane.

Observed capital structures

• Capital structure differs by industry• Example:

– Differences in Australian industries according to Table 13.5

• Media classification—Brisbane Broncos—0% debt• Utilities classification—Envestra—398.9% debt


Example: Work the Web

• You can find information about a company’s capital structure relative to its industry and sector using industry centre or sector analysis through Yahoo! Finance.

• Click on the information icon to go to the site– Choose a company and get a quote– Perform sector and industry comparisons


http://au.finance.yahoo.com/

Bankruptcy process

• Business failure—business has terminated with a loss to creditors

• Legal bankruptcy—petition federal court for bankruptcy

• Technical insolvency—firm is unable to meet debt obligations

• Accounting insolvency—book value of equity is negative


Liquidation and reorganisation• Companies Act 1993 and the Liquidation

Regulations 1994.• Process

– A petition is filed in a federal court. A corporation may file a voluntary petition, or involuntary petitions may be filed against the corporation by several of its creditors.

– An administrator is appointed by the court or the creditors to take over the assets of the debtor. The administrator will attempt to liquidate the assets.

– When the assets are liquidated, after payment of the bankruptcy administration costs, the proceeds are distributed among the creditors.

– If any proceeds remain, after expenses and payments to creditors, they are distributed to the shareholders.


Liquidation and reorganisation (cont.)

• The distribution of liquidation proceeds is made according to section 556 of the Australian Government Corporations Law.

• Brief priority list (absolute priority rule)– 1. Administrative expenses associated with the bankruptcy.– 2. Other expenses arising after the filing of a bankruptcy petition, but before the

appointment of an administrator.– 3. Wages, salaries and superannuation contributions for employees owed before the

company goes into liquidation.– 4. Amounts due in respect of injury compensation owed before the company goes into

liquidation.– 5. Amounts due to employees for leave of absence owed before the company goes into

liquidation.– 6. Retrenchment payments payable to employees of the company. In New Zealand the

preferential payment under 3, 4, 5 and 6 is limited to $15 000 per employee.– 7. Payment to unsecured creditors.– 8. Payment to preference shareholders.– 9. Payment to ordinary shareholders.


Quick quiz

• Explain the effect of leverage on EPS and ROE.• What is break-even EBIT?• How do we determine optimal capital structure?• What is the optimal capital structure in the three

cases that were discussed in this chapter?• What is the difference between liquidation and

reorganisation?• What are the direct and indirect costs of

bankruptcy?


Chapter 13

END

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