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

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. Remind students that the WACC is the appropriate discount rate for the risk of the firm’s assets. We can find the value of the firm by discounting the firm’s expected future cash flows at the discount rate—the process is the same as for finding the value of anything else. Since value and discount rate move in opposite directions, firm value will be maximised when WACC is minimised. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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

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

Eagles Air Services Capital structure scenarios—Table 13.2 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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

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

Break-even EBIT—Example EPS = for both capital structures Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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

Eagle Air Services—Conclusion The effect of leverage depends on EBIT: When EBIT is higher, leverage is beneficial. Under the ‘expected’ scenario, leverage increases ROE and EPS. 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. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Homemade leverage and ROE—Example 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. The choice of capital structure is irrelevant if the investor can duplicate the cash flows on their own. Note that all of the positions require an investment of $2000. We are still ignoring taxes and transaction costs. If we factor in these market imperfections, homemade leverage will not work quite as easily, but the general idea is the same. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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 M&M Proposition I—The value of the firm is independent of its capital structure. M&M Proposition II—A firm’s cost of equity capital is a positive linear function of its capital structure. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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 Case III—Assumptions Bankruptcy costs Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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. The main point with case I is that it doesn’t matter how we divide our cash flows between our stockholders and bondholders, the cash flow of the firm doesn’t change. Since the cash flows don’t change and we haven’t changed the risk of existing cash flows, the value of the firm won’t change. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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. Remind students that case I is a world without taxes. That is why the term (1 – TC) is not included in the WACC equation. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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% Remind students that if the firm is financed with 45% debt, then it is financed with 55% equity. At this point, you may also need to remind them that one way to compute the D/E ratio is % debt / (1-%debt). The second question is used to reinforce that RA does not change when the capital structure changes. Many students will not immediately see how to get the % of equity from the D/E ratio. Remind them that D+E = V. We are looking at ratios, so the actual $ amount of D and E is not important. All that matters is the relationship between them. So, let E = 1. Then D/1 = 1.5; solve for D; D = 1.5. Then V = 1 + 1.5 = 2.5 and the percentage equity is 1 / 2.5 = 40%. They often don’t understand that the choice of E = 1 is for the sake of simplicity. If they are confused about the process, show them that it doesn’t matter what you set E as equal to, as long as you keep the relationships intact. So, let E = 5; then D/5 = 1.5 and D = 5(1.5) = 7.5; V = 5 + 7.5 = 12.5 and E/V = 5 / 12.5 = 40%. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

M&M Propositions I and II Figure 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. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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) Intuitively, an increase in financial leverage should increase systematic risk since changes in interest rates are a systematic risk factor and will have more impact the higher the financial leverage. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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) Business risk—The equity risk that comes from the nature of the firm's operating activities. Financial risk—The equity risk that comes from the financial policy (i.e. capital structure) of the firm. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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. Point out that the government effectively pays part of our interest expense for us; it is subsidising a portion of the interest payment. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Case II—Example Unlevered firm Levered firm EBIT 5000 Interest 500 500 Taxable Income 4500 Taxes (30%) 1500 1350 Net Income 3500 3150 CFFA 3650 The levered firm has 6250 in 8% debt, so the interest expense = .08(6250) = 500. CFFA = EBIT – taxes (depreciation expense is the same in either case, so it will not affect CFFA on an incremental basis). Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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 Point out that the increase in cash flow in the example is exactly equal to the interest tax shield. The assumption of perpetual debt makes the equations easier to work with, but it is useful to ask the students what would happen if we did not assume perpetual debt. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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 RU is the cost of capital for an unlevered firm = RA for an unlevered firm. VU is just the PV of the expected future cash flows from assets for an unlevered firm. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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

M&M Proposition I with taxes Figure 13.4 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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

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% Remind students that a D/E ratio = 1 implies 50% equity and 50% debt. The amount of leverage in the firm increased, the cost of equity increased, but the overall cost of capital decreased. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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

M&M summary Table 13.4 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

M&M summary Table 13.4 (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Bankruptcy costs Direct costs Financial distress 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 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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

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

Optimal capital structure Figure 13.5 Static theory of capital structure—The theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs 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 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The capital structure question Figure 13.6 Case I—With no taxes or bankruptcy costs: the value of the firm and its weighted average cost of capital are not affected by capital structure. Case II—With corporate taxes and no bankruptcy costs: the value of the firm increases and the weighted average cost of capital decreases as the amount of debt goes up. Case III—With corporate taxes under an imputation system and no bankruptcy costs: the value of the firm increases at a slower rate than in Case II, and the weighted average cost of capital decreases as the amount of debt goes up. Case IV—With corporate taxes and bankruptcy costs: the value of the firm VL, reaches a maximum at 0*, the optimal amount of borrowing. At the same time, the weighted average cost of capital, WACC, is minimised at D*/E*. Case V—With corporate taxes under an imputation system and bankruptcy costs: the value of the firm, VL, reaches a maximum at D*. the optimal amount of borrowing. At some time, the weighted average cost of capital, WACC, is minimised at D*/E*. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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 See Table 13.5 in the textbook for more detail. Search for similar anomalies in the table, in different classifications. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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

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 Bankruptcy—A legal proceeding for liquidating or reorganising a business. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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. The Insolvency and Trustee Service Australia has a good overview of bankruptcy in the 'Bankruptcy' section on its website <www.itsa.gov.au>. In New Zealand, a similar service can be found at <www.ird.govt.nz/yoursituation-ind/ debt/bankruptcy.html> and <www.insolvency.govt .nz/cms>. Liquidation —Termination of the firm as a going concern. Reorganisation—Financial restructuring of a failing firm to attempt to continue operations as a going concern. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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. Absolute priority rule (APR)—The rule establishing priority of claims in liquidation. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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

Chapter 13 END