T16.1 Chapter Outline

Chapter 16Financial Leverage and Capital Structure Policy

Chapter Organization

16.1 The Capital Structure Question

16.2 The Effect of Financial Leverage

16.3 Capital Structure and the Cost of Equity Capital

16.4 M&M Propositions I and II with Corporate Taxes

16.5 Bankruptcy Costs

16.6 Optimal Capital Structure

16.7 The Pie Again

16.8 Observed Capital Structures

16.9 A Quick Look at the Bankruptcy Process

16.10 Summary and Conclusions

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T16.2 What’s Your Financing I.Q.?1. What do you need funding for?

a. To expand the businessb. To assist with business operationsc. To start the business

2. Describe your company’s profit history.a. A steady upward climbb. Even or flat, but steadyc. Inconsistent, or downward-sloping

3. How old is the business?a. Three or more yearsb. One to three yearsc. Less than one year

4. How well known are you within your market?a. Very well knownb. Somewhat knownc. Not known at all

5. Describe your company’s business plan. a. Formal, complete, and current b. Informal, but current c. We have no formal business plan

6. How do you handle financial controls? a. Formally b. Some formally, some informally c. There are no official controls in this area

7. What is your company’s ratio of assets to liabilities, compared to your competitors? a. Higher b. Equal c. Lower

8. For how many of these functions do you have yourself: marketing, production, human resources, office management, finance? a. Almost all of them b. Half of them

c. Two or less of them

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T16.2 What’s Your Financing I.Q.? (concluded)

Scoring your business:

For each A answer, give yourself 10 points, 5 points for each B, and 0 points for each C.

60 points or above: It won’t take much to convince a lender that you’re worthy of financing.

50 - 59 points: You’re on the right track. Seek out lenders who are familiar with firms of your size and industry.

35 - 49 points: Obtain funds from government-subsidized programs such as the Small Business Administration (SBA).

Below 35: Take a close look at your company and consider making adjustments before you seriously consider seeking external financing.

Source: Adapted from : “What’s Your Financing I.Q?” Datamerge Corporation.

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T16.3 Capital Structure, Cost of Capital, and the Value of the Firm

Key issues: What is the relationship between capital structure and firm value?

What is the optimal capital structure?

Preliminaries: Capital structure is flexible

Capital restructurings

Optimal capital structure: firm value vs. stock value

Optimal capital structure: firm value vs. WACC

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T16.4 Example: Computing Break-Even EBIT

Ignoring taxes:

A. With no debt:

EPS = EBIT/500,000

B. With $2,500,000 in debt at 10%:

EPS = (EBIT - $______)/250,000

C. These are equal when:

EPSBE = EBITBE/______ = (EBITBE - $250,000)/250,000

D. With a little algebra:

EBITBE = $500,000

So EPSBE = $___ /share

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T16.5 Financial Leverage, EPS and EBIT

EBIT ($ millions, no taxes)

EPS ($)

0 0.2 0.4 0.6 0.8 1

3

2.5

2

1.5

1

0.5

0

– 0.5

– 1

D/E = 1

D/E = 0

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T16.6 Example: Homemade Leverage and ROE

Firm does not adopt proposed capital structureInvestor puts up $500 and borrows $500 to buy 100 shares

EPS ofunlevered firm $0.60 $1.30 $1.60

Earnings for100 shares $60.00 $130.00 $160.00

less interest on$500 at 10% $50.00 $50.00 $50.00

Net earnings $10.00 $80.00 $110.00

ROE 2% 16% 22%

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T16.6 Homemade Leverage: An Example (concluded)

Firm adopts proposed capital structureInvestor puts up $500, $250 in stock and $250 in bonds

EPS oflevered firm $0.20 $1.60 $2.20

Earnings for25 shares $5.00 $40.00 $55.00

plus interest on$250 at 10% $25.00 $25.00 $25.00

Net earnings $30.00 $65.00 $80.00

ROE 6% 13% 16%

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T16.7 Milestones in Finance: The M&M Propositions

Financial leverage and firm value: Proposition I

Since investors can costlessly replicate the financing decisions of the firm (remember “homemade leverage”?), in the absence of taxes and other unpleasantries, the value of the firm is unaffected by its capital structure.

Corollary #1: There is no “magic” in finance - you can’t get something for nothing.

Corollary #2: Capital restructurings don’t create value, in and of themselves. (Why is the last part of the statement so important? Stay tuned.)

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T16.7 Milestones in Finance: The M&M Propositions (concluded)

The cost of equity and financial leverage: Proposition II

A. Because of Prop. I, the WACC must be constant. With no taxes,

WACC = RA = (E/V) RE + (D/V) RD

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

B. Solve for RE to get MM Prop. II

RE = RA + (RA - RD) (D/E)

( ) Cost of equity has two parts:

1. RA and “business” risk

2. D/E and “financial” risk

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T16.8 The Cost of Equity and the WACC (Figure 16.3)

Debt-equity ratio, D/E

Cost of capital

WACC = RA

RD

RE = RA + (RA – RD ) x (D/E)

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T16.9 The CAPM, the SML, and Proposition II

The effect of financing decisions on firm risk is reflected in both M&M’s Proposition II and in the CAPM.

Consider Proposition II: All else equal, a higher debt-equity ratio will increase the required return on equity, RE.

M&M Proposition II: RE = RA + (RA - RD) (D/E)

The effect of financing decisions is reflected in the equity beta, and, by the CAPM, increases the required return on equity.

CAPM: RE = RF + (RM - RF) E

In other words, debt increases systematic risk (and moves the firm along the SML).

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T16.10 Business Risk and Financial Risk

By M&M Proposition II, the required return on equity arises from two sources of firm risk. Proposition II is:

RE = RA + (RA - RD) (D/E)

Business risk - equity risk that comes from the nature of the firm’s operating activities (measured by RA in the equation above); and

Financial risk - equity risk that comes from the financial policy (i.e., capital structure) of the firm. Financial risk is measured by (RA - RD) (D/E) in the equation above.

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T16.11 Debt, Taxes, Bankruptcy, and Firm Value

The interest tax shield and firm valueFor simplicity: (1) perpetual cash flows

(2) no depreciation(3) no fixed asset or NWC spending

A firm is considering going from zero debt to $400 at 10%:

Firm U Firm L(unlevered) (levered)

EBIT $200 $200Interest 0 $40Tax (40%) $80 $64Net income $120 $96Cash flowfrom assets $120 $____

Tax saving = $16 = ____ $40 = TC RD D

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T16.11 Debt, Taxes, Bankruptcy, and Firm Value (concluded)

What’s the link between debt and firm value?

Since interest creates a tax deduction, borrowing creates a tax shield. Its value is added to the value of the firm.

MM Proposition I (with taxes)

PV(tax saving) = $16/____ = $____

= (TC RD D)/RD = TC D

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T16.12 M&M Proposition I with Taxes (Figure 16.4)

Total debt (D)

Value of the firm

(VL)

VU

VL = VU + TC x D

= TC

VU

TC x DVL= $7,300

VU= $7,000

$1,000

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T16.13 Example: Debt, Taxes, and the WACC

Taxes and firm value: an example EBIT = $100 TC = 30% RU = 12.5%

Q. Suppose debt goes from $0 to $100 at 10%, what happens to equity value, E?

VU = $100 (______)/.125 = $560

VL = $560 + .30 $_____ = $590, so E = $_____ .

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T16.13 Example: Debt, Taxes, and the WACC (concluded)

WACC and the cost of equity (MM Proposition II with taxes)

With taxes:

RE = RU + (RU - RD) (D/E) (1 - TC )

RE = _____+ (_____- .10) ($____/____) (1 - .30)

= 12.86%

WACC = ($____/____) .1286 + (100/590) .10 (1 - .30)

= 11.86%

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T16.14 Taxes, the WACC, and Proposition II

Debt-equity ratio, D/E

Cost of capital (%)

RU

RD (1 – TC)

RE

WACC

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T16.15 The Cost of Equity and the WACC: M&M Proposition II with Taxes (Figure 16.5)

Debt-equity ratio, D/E

Cost of capital (%)

RU

RD (1 – TC)

RE

WACC

RE = 10.22%

RU = 10%

WACC = 9.6%

RD (1 – TC)

= 8% (1 - .30)= 5.6%

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T16.16 Modigliani and Miller Summary (Table 16.6)

I. The No-Tax Case

A. Proposition I: The value of the firm levered equals the value of the firm unlevered:

VL = VU

Implications of Proposition I:

1. A firm’s capital structure is irrelevant.

2. A firm’s WACC is the same no matter what mix of debt and equity is used.

B. Proposition II: The cost of equity, RE, is

RE = RA + (RA - RD) D/E

where RA is the WACC, RD is the cost of debt, and D/E is the debt/equity ratio.

C. Implications of Proposition II

1. The cost of equity rises as the firm increases its use of debt financing.

2. The risk of equity depends on the risk of firm operations and on the degree of financial leverage.

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T16.16 Modigliani and Miller Summary (Table 16.6) (concluded)

II. The Tax Case

A. Proposition I with Taxes:

The value of the firm levered equals the value of the firm unlevered plus the present value of the interest tax shield:

VL = VU + TcD

where Tc is the corporate tax rate and D is the amount of debt.

B. Implications of Proposition I:

1. Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is 100 percent debt.

2. A firm’s WACC decreases as the firm relies more heavily on debt financing.

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Borrowing money is a good news/bad news proposition.

The good news: interest payments are deductible and create a “debt tax shield” (i.e., TCD).

The bad news: all else equal, borrowing more money increases the probability (and, therefore, the expected value) of direct and indirect bankruptcy costs.

Key issue: The Impact of Financial Distress on Firm Value

The Static Theory of Capital Structure

The theory that a firm borrows up to the point where the tax benefit from an extra dollar of debt is exactly equal to the cost that comes from the increased probability of financial distress.

T16.17 The Optimal Capital Structure and the Value of the Firm

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T16.17 The Optimal Capital Structure and the Value of the Firm (continued) (Figure 16.6)

Value ofthe firm

(VL )

Debt-equity ratio, D/EOptimal amount of debtD/E

Present value of taxshield on debt

Financial distress costs

Actual firm value

VU = Value of firm with no debt

VL = VU + TC D

Maximumfirm value VL*

VU

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T16.18 The Optimal Capital Structure and the Cost of Capital (Figure 16.7)

Cost ofcapital

(%)

Debt/equity ratio (D/E)D*/E*

The optimal debt/equity ratio

RU

WACC

RD (1 – TC)

RE

RU

WACC*Minimum cost of capital

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T16.19 The Capital Structure Question (Figure 16.8)T16.19 The Capital Structure Question (Figure 16.8)

Value ofthe firm

( VL )

Total debt (D)

D*

PV of bankruptcy costs

Case III Static TheoryCase IM&M (no taxes)

VL*

VU

Case IIM&M (with taxes)

Net gain from leverage

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T16.20 The Extended Pie Model (Figure 16.9)

Lower financial leverage

Bondholderclaim

Bankruptcyclaim

Taxclaim

Stockholderclaim

Higher financial leverage

Bondholderclaim

Bankruptcyclaim

Taxclaim

Stockholderclaim

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T16.21 Chapter 16 Quick Quiz

1. Why does the firm’s cost of equity increase with leverage?

All else equal, as the D/E ratio increases, the riskiness of the remaining equity increases.

2. What are direct bankruptcy costs?

Direct bankruptcy costs are generally observable and, therefore, measurable. Examples: legal fees, accounting fees, administrative expenses.

3. What kinds of firms would be most likely to suffer indirect bankruptcy costs?

Firms most likely to lose customers and/or sales as the likelihood of distress increases.

4. Name three types of financial distress.

Business failure; legal bankruptcy; technical insolvency