1 課程 12: Financial Leverage and Capital Structure Policy

2 How to decide the optional capital structure? What’s the objective? –maximize firm value –minimize WACC A particular debt/equity ratio represents the optional capital structure if it results in the lowest possible WACC.

3 Financial Leverage 財務槓桿／ Financial Risk 財務風險 Financial leverage affects the payoffs to stockholders. An example: Panel A: Current capital structure: no debt

4 Panel B: Proposed capital structure: debt = 4 million

5 EPS vs. EBIT 每股盈餘無異分析

6 Break-even point EPS will be the same for both capital structures:

7 Example Before: 200,000 shares * share = $4,000,000 Debt 1,000,000 After 3,000,000 /20 150,000 shares

8 Conclusion The effect of financial leverage depends on the firm’s EBIT. When EBIT is relatively high, leverage is beneficial. Shareholders are exposed to more risk under the proposed capital structure since the EPS and ROE are much more sensitive to change in EBIT.

9 Question Because of the impact that financial leverage has on both the expected return to stockholders and the riskness of the stock, capital structure is an important consideration. Answer: no. ∵ Shareholders can adjust the amount of financial leverage by borrowing and lending on their own. The use of personal borrowing to alter the degree of financial leverage is called homemade leverage.

10 Homemade leverage Panel A: proposed capital structure

11 Panel B: original capital structure and homemade leverage

12 Investors can always increase financial leverage themselves to create a different pattern of payoffs. It thus makes no different whether a firm restructure the capital structure. There is nothing special about corporate borrowing because investors can borrow or lend on their own. As a result, whichever capital structure a firm chooses, the stock price will be the same.

13 M&M proposition I: Modigliani and Miller The value of the firm is independent of its capital structure. Example:.firm value distribution: stockholders vs. debtholders..whole milk: cream vs. skim milk..pie: more pieces, but not more pizza. The size of the pizza does not depend on how it is sliced.

14 M&M proposition II A firm’s cost of equity is a positive linear function of its capital structure. assuming no tax

15 M&M propositions with corporate tax Properties of debt –tax benefit vs. bankruptcy cost Example: Firm U: unlevered, Firm L: levered. Assuming two firms are identical on the left-hand side of the balance sheet, only different on capital structure.

16 The interest tax shield Cash flow to stockholders and bondholders

17 $80*30%=24: This tax saving is called interest tax shield The value of tax shield is present value of the interest tax shield = M&M proposition I with tax Suppose, which we call is as the unlevered cost of capital.

18 The analysis implies that, once we include taxes, the optimal capital structure is 100% debt.

19 M&M proposition II with tax Without debt, the WACC is 10%, and, with debt, the WACC is 9.6%. The firm is better off with debt.

20 Example:

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22 Debt has tax benefit, but also has cost, bankruptcy cost. Bankruptcy costs: Direct bankruptcy cost Indirect bankruptcy cost

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