Copyright: M. S. Humayun1 Financial Management Lecture No. 34 Optimal Capital Structure – Impact of Debt on Firm Value & WACC Graphs

Copyright: M. S. Humayun2 Recap of WACC & Firm Risk WACC % = r D X D + r E X E + r P X P. 3 Basic Forms of Raising Capital: D=Debt, E=Common Equity, & P=Preferred Equity. Uses Required ROR’s adjusted by Taxes and Transaction Costs. “x” represent fractions of MARKET VALUES of Debt or Equity. Should NOT use the Book Values from Financial Statements used in Financial Accounting. –Two Ways to Raise Equity Capital: (1) Retained Earnings which is cheap way to raise equity AND (2) New Stock Issue which is more costly –Two Ways to Calculate rE (Required ROR on Equity): (1) Gordon’s Formula for Stock Pricing : rE = (DIV1/Po) + g AND (2) CAPM Theory / SML : rE = rRF + (rM – rRF)Beta Total Stand Alone Risk of Firm = Business Risk + Financial Risk Business Risk = Standard Deviation of ROE of Un-levered Firm –Operating Leverage (OL) = Fixed Cost / Total Cost. OL increases Business Risk. Small Change in Sales Causes Large Change in Operating Income & ROE. OL can be Good when Sales > Breakeven. Financial Risk = Total Risk for Levered Firm - Business Risk –Financial Leverage = Market Value of Debt / Market Value of Total Assets = D / (D+E): FL increases Financial Risk. Small Change in EBIT Causes Large Change in ROE. FL can be Good when EBIT/Assets > Interest. –Leverage Rises. Financial Distress & Higher chance of Bankruptcy. Banks charge Higher Interest Rates. Higher Cost of Debt. Higher Risk. Higher Beta. Higher Required Return on Equity ( r E ). Higher Cost of Equity.

Copyright: M. S. Humayun3 Recap of Capital Structure Theories Miller Modigliani (MM) Theory – Case of Ideal World & Efficient Markets –Capital Structure, DEBT, & Corporate Financing have NO AFFECT on Capital Budgeting, MARKET VALUE OF FIRM (V), NPV, & Investment Decisions –Remember that in Efficient Markets, the Fair Value of a Firm (calculated using NPV) is approximately equal to the Market Value. The Firm’s Value is determined by the Future Cash Flows generated by the Firm (or Real Assets) and NOT by the way the cash flows are split or divided amongst the Debt and Equity Holders. –Market Value of Firm = V = EBIT / WACC. As Debt Increases, Risk Increases so rD and rE and WACC should increase. BUT Debt is cheaper than equity (recall Risk Theory) so as Debt Increases, WACC should decrease ! Net Effect is No Change in WACC and No Change in Value ! –Major Assumptions: No Taxes, No Bankruptcy Costs, Equal Information, Efficient Markets MM Theory with Taxes –Corporate Tax favors Debt Financing because of Interest Tax Shield. Personal Tax favors Equity Capital. Net Effect is that Taxes favors raising Capital through Debt Financing. Tradeoff Theory (With Taxes & Financial Distress / Bankruptcy) –When Excessive Leverage (Debt or Borrowing) then Bankruptcy Costs begin to Outweigh Benefits of Interest Tax Shield or Savings. At first, Firm’s Value Rises because of Interest Tax Savings but as Debt increases, the Value reaches a Maximum Point (where WACC is minimum) and then at excessive Debt levels, the Value begins to fall. Signaling Theory (Market Signals) –New Equity Issue gives signal to Market Investors that Firm’s financial future looks bad so Market Price of Stock often falls. Cost of Equity and Required ROR on Equity (r E ) increases. –Debt Financing signals strong future earnings. Firms should save some Spare or Reserve Debt Capacity in case they find an attractive Project or Investment. –Save Some Spare or ReserveDebt Capacity for good investment opportunity. Give right signal to market.

Copyright: M. S. Humayun4 Effect of Leverage on Cost of Debt & Equity Effect of Financial Leverage (or Debt) on Cost of Debt (rD): –At Low Leverage, Increase in Leverage leads to Slight Increase in Overall Risk and Return of Firm. –At Higher Leverage, Risk of Financial Distress & Bankruptcy. Banks Raise Interest Rate Charges. Cost of Debt Rises Faster. Required ROR of Firm’s Debt Holders (r D ) Rises Faster. Effect of Financial Leverage (or Debt) on Cost of Equity (rE): –Firm’s Total Risk Rises Slowly at Low Leverage and Faster when Leverage becomes Excessive and Risk of Financial Distress arises. Firm’s Stock Beta Rises. Firm’s Stock Required ROR (r E ) Rises. WACC = rDxD + rExE (assuming no Preferred Equity): –Effect of Debt on WACC changes depending on choice of Theory. –Pure MM Theory: WACC does Not Change. WACC curve is Flat. –Traditionalist Theory (and Tradeoff Theory): WACC curve is broad U- shaped Parabola with Minimum WACC point.

Copyright: M. S. Humayun5 Effect of Leverage on WACC WACC: Effect of Debt on WACC Changes. –Pure MM View (Ideal Efficient Markets): No Taxes and No Bankruptcy Costs. Debt increases Risk BUT is also Cheaper than Equity so NO Net Effect on WACC. So, Change in Debt has no effect on WACC and Value. WACC curve is Flat. –Traditionalist View (Tradeoff Theorists, Real Markets): Combined Effect of Taxes and Financial Distress / Bankruptcy Costs is a Flat U-Shaped WACC Curve with a Minimum Point which represents the Optimal Capital Structure (ie. Best Debt Ratio for the Firm).

Copyright: M. S. Humayun6 Pure MM Theory - Ideal Markets WACC Graph WACC = r D x D + r E x E r E = Cost of Equity =WACC+D/E (WACC - r D ) r D = Cost of Debt Cost of Capital (%) Debt / Equity = D/E = x D / ( 1- x D ) rErE rDrD 100% Equity Firm Financial Risk. Higher Required Return on Equity. Higher r E

Copyright: M. S. Humayun7 MM View - Ideal Markets Example A 100% Equity Firm (or Un-levered) has Total Assets of Rs It has a WACC U of 21% (= r E,U ) and r D,U of 10%. It then adds Rs 400 of Debt. Financial Risk increases r D,L of Levered Firm to 13%. What is the Levered Firm’s r E,L and WACC L ? Assuming Pure MM View - Ideal Markets. Total Market Value of Assets of Firm (V) is UNCHANGED. V U = V L. Also, WACC UNCHANGED by Capital Structure and Debt. WACC U = WACC L = 21% r E,L =WACC + D/E (WACC - r D,L ) = 21% + 400/600 (21% - 13%) = 26.3% r E,L = (WACC - r D,L x D )/ x E = (21% - 13% (400/1000)) / (600/1000) = 26.3% Cost of Equity for Levered Firm = rE,L = Risk Free Interest Rate + Business Risk Premium + Financial Risk Premium. r E,L Increases because Required ROR for Stock Increased because of Financial Risk

Copyright: M. S. Humayun8 Pure MM Ideal Markets - Example Example: Assuming Pure MM Theory with Ideal Efficient Markets where Total MARKET VALUE of Assets of Firm (V =D+E) is UNCHANGED by the Capital Structure (and Leverage). Given the following Data on Leverage and Cost of Capital: Debt (D)Interest (r D )Equity Cost of Equity (E = V-D)(r E = (WACC- r D x D )/ x E ) Rs 0(=V)0Rs % (=WACC) Un-Levered Rs 20010% (r RF )Rs 800(21% - 10%(0.2))/0.8 = 23.75% Rs 30011%Rs 700(21% - 11%(0.3))/0.7 = 25.3% Rs 40013%Rs 600(21% - 13%(0.4))/0.6 = 26.3% Rs 50015%Rs 200(21% - 15%(0.8))/0.2 = 45% Problem:In Real Markets, Total Market Value of Firm (V) DOES CHANGE as Leverage Increases.

Copyright: M. S. Humayun9 Tradeoff Theory Graph – Linked to Traditionalist Theory of Leverage & Optimal Capital Structure Slightly Leveraged Firm: Interest Tax Shield Benefit. Total Return to Investors Rises so Stock Value Rises. Total Return = Net Income (paid to Shareholders) + Interest (paid to Debt Holders) Value of Firm or Price of Stock Financial Leverage = Debt / Assets = D/(D+E) OPTIMAL Capital Structure - MAXIMUM VALUE & MINIMUM WACC Excessively Leveraged Firm: Threat of Bankruptcy has Real Costs. Less Investor Confidence and Lower Share Price. Firm Remains 100% Equity (Un-Levered)

Copyright: M. S. Humayun10 Traditionalist Theory - Real Markets WACC Graph WACC L = r D (1-Tc) x D + r E x E r E,L = Cost of Equity = WACC U + x D (WACC U - r D ) (1-T C ) r D = Cost of Debt Cost of Capital (%) Debt / Equity = D/E = x D / ( 1- x D ) rErE rDrD 100% Equity Firm Bankruptcy Risk & Costs. Higher Required Return on Equity. Steeper Rise. Interest Tax Shield Advantage Optimal Capital Structure Note: x D = D / (D+E)

Copyright: M. S. Humayun11 Traditionalist View - Example Same Example: A 100% Equity Firm (or Un-levered) had Total Assets of Rs It had a WACC U of 21% (= r E,U ). It then added Rs 400 at a Cost of Debt r D,L (for Levered Firm) of 13%. What is the Levered Firm’s r E,L and WACC L ? Given Data for r E, Corporate Tax Rate of 30% on EBT, and EBIT = Rs 300. Traditionalist View is based on Practical Reality. Leverage provides Interest Tax Savings (or Shield) but also Increases Financial Risk. Excessive Leverage leads to Bankruptcy Risk. Increase in Risk will Change Value of Firm and WACC. Now r E is based on Observed Data. And Equity Value (E) is Based on Simple Income Statement Formulas. Traditionalists Formulas for Equity: E = NI / r E,L Note: NI = EBIT - Interest - Tax = EBT - Tax NI = (EBIT - x D r D ) (1 - Tc). r E,L = WACCu + x D (WACCu - r D ) (1 - Tc). Traditionalists Formula for WACC: WACC L = x D r D (1 - Tc) + x E r E. (1-Tc) is the Tax Discount Factor. Note: V = D + E x D = D /V = D / (D+E) x D + x E = 1 V = Market Value of Firm D = Market Value of Debt E = Market Value of Equity xD = Fraction of Debt = A Measure of Leverage