FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTERSIXTEEN Capital Structure

Learning Objectives 1. Describe leverage and how it affects companies. 2. Define indifference analysis, how it is used, and what it measures. 3. Explain how the value of a company is established. 4. Name two reasons why the cost of a security to a company differs from its yield in capital markets. 5. Describe how debt capacity affects a company.

Introduction In this chapter we investigate: In this chapter we investigate: the alternative capital structures with respect to change in the proportions of debt and equity the alternative capital structures with respect to change in the proportions of debt and equity the theory that explores how various degrees of leverage should be valued by investors the theory that explores how various degrees of leverage should be valued by investors the market imperfections and considerations when evaluating debt levels the market imperfections and considerations when evaluating debt levels

Leverage and Financial Risk Leverage is encountered whenever fixed costs are incurred to support operations that generate revenue Leverage is encountered whenever fixed costs are incurred to support operations that generate revenue Operating leverage – when a portion of a company’s operating costs are fixed Operating leverage – when a portion of a company’s operating costs are fixed Financial leverage – when a firm finances part of its business with securities that entail fixed financing charges such as bond, debentures, or preferred shares Financial leverage – when a firm finances part of its business with securities that entail fixed financing charges such as bond, debentures, or preferred shares A firm’s financial results that accrue to equity investors are magnified through the use of operating and financial leverage A firm’s financial results that accrue to equity investors are magnified through the use of operating and financial leverage

Leverage and Financial Risk Operating and Financial Leverage

Leverage and Financial Risk A firms total leverage is a combination of operating and financial leverage and measures the % variation in EPS for a given % change in sales A firms total leverage is a combination of operating and financial leverage and measures the % variation in EPS for a given % change in sales Increased leverage leads to increased risk Increased leverage leads to increased risk Business risk – results from general economic cycles, changing industry conditions, and operating cost structure of an individual firm Business risk – results from general economic cycles, changing industry conditions, and operating cost structure of an individual firm Degree of financial leverage – is the % change on common equity or EPS divided by the % change in EBIT that caused the change in equity returns Degree of financial leverage – is the % change on common equity or EPS divided by the % change in EBIT that caused the change in equity returns

Leverage and Financial Risk If only common equity is used changes in ROE reflect only business risk If only common equity is used changes in ROE reflect only business risk Financial leverage = 1 Financial leverage = 1 If senior securities are used in the capital structure the variations on ROE are magnified If senior securities are used in the capital structure the variations on ROE are magnified Financial leverage > 1 Financial leverage > 1 Total value of the firms is expressed by: Total value of the firms is expressed by: Value of firm = value of debt + value of equity

Indifference Analysis Indifference analysis is a common tool used in assessing the impact of leverage and is used to: Indifference analysis is a common tool used in assessing the impact of leverage and is used to: determine EPS as a function of EBIT for various capital structures determine EPS as a function of EBIT for various capital structures identify the level of EBIT beyond which reliance on leverage produces higher EPS identify the level of EBIT beyond which reliance on leverage produces higher EPS

Indifference Analysis Limitations of indifference analysis include: Limitations of indifference analysis include: 1. It ignores cash flow considerations such as sinking fund provisions for the periodic retirement of fixed income securities. 2. It does not consider how equity investors may react to the increased risk imposed by leverage in the light of uncertain future operating performance.

Evaluation of Capital Structures A capital structure that maximizes share prices generally will minimize the firm’s WACC A capital structure that maximizes share prices generally will minimize the firm’s WACC If a firm can lower its WACC, shareholders will receive greater returns reflected in increased share prices If a firm can lower its WACC, shareholders will receive greater returns reflected in increased share prices capital structure capital structure  market price per share,  WACC  market price per share,  WACC

Evaluation of Capital Structures Different capital structures results in different levels of financial risk created through leverage. Different capital structures results in different levels of financial risk created through leverage. Three trade-off possibilities include: Three trade-off possibilities include: 1. Cost equity increases with leverage at a moderate rate so that when combined with debt l WACC decreases with increased leverage 2. Cost of equity increases at a rate that offsets the benefits gained through cheaper financing l WACC remains constant 3. Cost of equity increases rapidly with leverage and increase more than offsets any gains from debt l WACC increases with leverage

Evaluation of Capital Structures Consequences of Different Shareholder Attitudes Toward Risk

Evaluation of Capital Structures Leverage is measured as the proportion of debt in relation to equity in the capital structure (B/E) Leverage is measured as the proportion of debt in relation to equity in the capital structure (B/E) With V = B + E WACC is: With V = B + E WACC is:

Traditional Position Under the traditional position firms can: Under the traditional position firms can: issue reasonable amounts of debt with little effect on its cost of equity and a low risk of default issue reasonable amounts of debt with little effect on its cost of equity and a low risk of default Corporations use debt to take advantage of the positive aspects of leverage Corporations use debt to take advantage of the positive aspects of leverage It is important for companies to find the optimal level where the WACC is minimized It is important for companies to find the optimal level where the WACC is minimized

Traditional Position The Traditional Position on Capital Structure and the Cost of Capital

Theory of Capital Structure Capital structure without taxes and bankruptcy costs Capital structure without taxes and bankruptcy costs denoting k e u and k e L as the cost of equity for unlevered and levered firms we have: denoting k e u and k e L as the cost of equity for unlevered and levered firms we have: rearranged we get: rearranged we get:

Theory of Capital Structure Relationship Between the WACC, Cost of Equity, and Leverage

Theory of Capital Structure Corporate taxes Corporate taxes exert an important influence on financing decisions because the amount of taxes depends on the capital structure exert an important influence on financing decisions because the amount of taxes depends on the capital structure levered firm’s taxes are reduced by the tax shield on interest (IT) levered firm’s taxes are reduced by the tax shield on interest (IT) V L > V u V L > V u Ignoring bankruptcy, investors would prefer owning debt and equity of L over equity U Ignoring bankruptcy, investors would prefer owning debt and equity of L over equity U

Theory of Capital Structure Assuming debt outstanding (B) is perpetual and the tax shield generated by interest payments becomes a perpetual annuity of IT then: Assuming debt outstanding (B) is perpetual and the tax shield generated by interest payments becomes a perpetual annuity of IT then: Present value of tax savings = then

Theory of Capital Structure l The cost of equity k e L increases at a slower rate, which can be seen through the formulas:

Theory of Capital Structure Individual taxes can influence the value of a company, therefore they must be considered for decisions on capital structure Individual taxes can influence the value of a company, therefore they must be considered for decisions on capital structure A company wants a capital structure that minimizes total taxes or maximizes after-tax distribution A company wants a capital structure that minimizes total taxes or maximizes after-tax distribution Total after-tax distribution

Theory of Capital Structure Cash Flow with Corporate and Personal Taxes

Theory of Capital Structure Bankruptcy Costs Bankruptcy Costs As firms increase financial leverage they increase the probability of bankruptcy As firms increase financial leverage they increase the probability of bankruptcy Regardless of ownership any enterprise that generates a positive NPV should continue operating Regardless of ownership any enterprise that generates a positive NPV should continue operating Ý Bankruptcies often reduce a firm’s economic value because: 1. the direct costs such as fees for trustees, lawyers, and court proceedings 2. the loss of profits caused by the loss of trust in the company

Theory of Capital Structure Benefit of Tax Savings, Expected Bankruptcy Costs, and Optimal Capital Structure

Market Imperfections and Practical Considerations Agency Problems Agency Problems when managers fail to act in the best interests of shareholders when managers fail to act in the best interests of shareholders Market Inefficiencies Market Inefficiencies Imperfections in the markets cause share prices to fall whenever companies issue equity no matter if the stock is undervalued, overvalued, or valued correctly. Imperfections in the markets cause share prices to fall whenever companies issue equity no matter if the stock is undervalued, overvalued, or valued correctly. Based on the imperfections, companies should issue bonds when internal equity is not available and only issue equity as a last resort, which gives rise to the “pecking order” of corporate finance Based on the imperfections, companies should issue bonds when internal equity is not available and only issue equity as a last resort, which gives rise to the “pecking order” of corporate finance

Market Imperfections and Practical Considerations l “Pecking order” of finance holds that 1. Retained earnings or depreciation should be used first 2. After internal resources are depleted, debt should be used 3. New common equity should be issued only when more debt is likely to increase the chance of bankruptcy Debt capacity Debt capacity Debt capacity – the ability of an enterprise to tolerate higher leverage Debt capacity – the ability of an enterprise to tolerate higher leverage

Market Imperfections and Practical Considerations Considerations determining the debt capacity of a firm include: Considerations determining the debt capacity of a firm include: debt capacity can be viewed as a function of both collateral and stable cash flow debt capacity can be viewed as a function of both collateral and stable cash flow the variability and level of cash flow during difficult times influences debt capacity the variability and level of cash flow during difficult times influences debt capacity firms with product lines that involve long- term commitments to customers have a lower debt capacity firms with product lines that involve long- term commitments to customers have a lower debt capacity

Summary 1. A firm that incurs fixed costs while generating variable revenues is subject to leverage. Leverage is used to increase the expected profitability of a firm. Financial risk is the added variability in returns to shareholders introduced by financing through fixed-cost senior securities. 2. Indifference analysis is used to evaluate the effect of leverage on profitability.

Summary 3. A firm’s capital structure is optimal if it maximizes shareholder wealth. The desirability of financial leverage depends on equity investors’ attitudes toward the implied trade-offs between risk and expected returns. The traditional position suggests, optional moderate leverage. 4. Given corporate taxes, interest on debt allows the firm to reduce its tax bill and to increase the amount available for distribution to security holders.

Summary 5. Firms restrict debt financing in order to limit the probability of financial distress. Liquidation decisions entail capital budgeting analysis that is based on net present values. Total expected bankruptcy costs increase with financial leverage and reduce the value of the firm. The trade-off facing management is between the tax benefits that accrue through debt financing and the expected costs of financial distress that increase with leverage.

Summary 6. Since debt payments represent contractual obligations, high leverage reduces a firm’s free cash flow. It thus limits management flexibility and discretion. A firm’s debt capacity is mainly a function of the stability of its cash flow and its collateral’s value and liquidity. 7. Financial leverage affects a firm’s systematic risk. Beta, as specified by the Capital Asset Pricing Model, varies as a function of the debt proportion that the firm employs.