16-0 Financial Leverage and Capital Structure Policy Chapter 16 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter Outline Financial Leverage The Effect of Leverage Capital Structure Theory: - M&M Proposition I & II without Taxes - M&M Proposition I & II with Taxes Bankruptcy Costs & the Static Theory of CS The Pecking-Order Theory of CS Observed Capital Structures The Bankruptcy Process 1

Financial Leverage Financial Leverage: How much is in the capital structure. Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets. Goal: Choose the capital structure that will maximize. At that level of leverage, the WACC is. 2

The Effect of Leverage How does leverage affect the EPS and ROE of a firm? 3

The Effect of Leverage Leverage the variability of EPS and ROE. 4

The Effect of Leverage Break–Even Point of EBIT: (EBIT / # of shares no debt )= (EBIT - interest / # of shares with debt ) 5

The Effect of Leverage: Break- Even Example Currently a firm uses no debt but considers restructuring. After restructuring, debt will be $500,000 (interest on debt is 8%). The firm has currently 120,000 shares outstanding, and the price per share is $17. What is the minimum level of EBIT that the firm must earn so that the restructuring will increase EPS? 6

Homemade Leverage 7

Capital Structure Theory: M&M Propositions I & II Modigliani and Miller Theory of Capital Structure: –Proposition I: Relates Firm value to CS –Proposition II: Relates Cost of equity to CS 8

M &M Propositions I and II without Taxes Proposition I The value of the firm is NOT affected by changes in the capital structure Value of levered firm = value of unlevered firm V L = V U V L = EBIT/R E Proposition II R E = R A + (R A - R D ) x (D/E) Cost of equity capital increases as leverage increases 9

M&M Propositions I and II with Taxes Proposition I The value of the firm increases with debt by the present value of the annual interest tax shield Value of levered firm = value of unlevered firm + PV of interest tax shield V L = V U + (DxT) V L = EBIT(1-T)/R E + DxT Proposition II R E = R A + (R A - R D ) x (D/E) x (1-T) Cost of equity capital increases as leverage increases 10

M&M Proposition I with Taxes Example A company expects EBIT to be $25 million per year. If the company restructures, it will carry $75 million in debt. Assuming that the cost of debt is 9%, the tax rate = 35%, and the un-levered cost of capital is 12%, what it the value of the levered firm? 11

Bankruptcy Costs & The Static Theory of CS As the D/E ratio increases, the probability of bankruptcy At the “optimal” leverage ratio, the additional value of the interest tax shield will the bankruptcy cost 12

The Pecking-Order Theory of CS Firms prefer internal financing Debt is used if necessary Equity is sold as a last resort 13

Observed Capital Structures Capital structure differs by industries. Average Debt Ratios (2008): - Low levels of debt: Computer Companies: 5.31% Drug Companies: 6.76% Fabric apparel: 15.56% - High levels of debt: Cable television: 61.84% Airlines: 56.30% Electric Utilities: 49.40% Department Stores: 38.90% 14

15 Observed Capital Structures Source: Titman, Keon, Martin, Financial Management, 11 th ed, 2011

Bankruptcy Process Liquidation (Chapter 7) Used if t he firm is worth more than. (Use absolute priority rule) Reorganization (Chapter 11) Used if t he firm is worth more than. 16