CF Winter 2014

Corporate Finance 1 core idea rr activitiesfunders > If then

Jargon Alert! Financial Leverage  “lots of debt” Capital Structure  “Debt/Equity ratio”

Financial Leverage effect of financial leverage on  cash flows  cost of equity impact of taxes and bankruptcy on  capital structure choice

Capital Structure D/E ratio  How do we change it?  leverage  issue debt  buy outstanding shares  leverage  issue new shares  retire outstanding debt

Observed Capital Structures differ by industry  D/E ratio guide for lenders shareholders firm

Capital Structure D/E ratio  What happens if we change it?  D/E ratio  Leverage   rewards  punishments

Capital Structure  D/E ratio  Leverage  volatility »EPS »ROE  interest expense  taxes  good years  stock value  bad years  stock value

Financial Leverage suppose  $8massets  10%interest rate  rational market  $20share price 0.2m0.4mshares $4.0m-debt $4.0m$8.0mequity D/E=1no debt economyEBIT good$1.5m average$1.0m bad$0.5m no debt ROEEPS 18.75%$ %$ %$1.25 D/E=1 interestROEEPS $0.4m27.50%$5.50 “15.00%$3.00 “2.50%$0.50 ignore taxes (for now)

Choosing a Capital Structure goal:  maximize stockholder wealth 2 methods maximize firm value  or minimize WACC

Financial Leverage What is best amount?  use “break-even EBIT” as reference point where EPS same for both amounts of debt if we expect EBIT > break-even point  then leverage beneficial our stockholders if we expect EBIT < break-even point  then leverage detrimental to stockholders

Financial Leverage no debtD/E=1 ab interest i -$0.4m # shares s 0.4m0.2m break-even EBIT:

Modigliani & Miller Theory of Capital Structure  Proposition I: v firm value  Proposition II: WACC

M&M v determined by:  cash flows  risk of assets change v by:  change cash flows  change risk of cash flows

M&M Case I:No Taxes No Bankruptcy Costs  Proposition I v NOT affected by changes in capital structure cash flows don’t change, so v doesn’t change  Proposition II WACC NOT affected by changes in cap structure

M&M Case I:No Taxes No Bankruptcy Costs

M&M Case II:with Taxes No Bankruptcy Costs  interest tax deductible so:  debt  taxes  cash  v

M&M Case II:with Taxes No Bankruptcy Costs  Proposition I v IS affected by changes in capital structure cash flows change, so v changes  Proposition II WACC IS affected by changes in cap structure

M&M Case II:with Taxes No Bankruptcy Costs  Proposition I  Proposition II

M&M Case II:with Taxes No Bankruptcy Costs

M&M Case II:with Taxes No Bankruptcy Costs

M&M Case III:with Taxes with Bankruptcy Costs  risks to shareholders to bondholders  constraint on debt financing  legal & administrative problems management focus lost lost sales interrupted operations loss of valuable employees

M&M Case III:with Taxes with Bankruptcy Costs  interest still tax deductible  bankruptcy risks  debt  chance of bankruptcy  risk  WACC

M&M Case III:with Taxes with Bankruptcy Costs  Proposition I v increases initially due to tax benefit of debt  until overwhelmed by bankruptcy risk  Proposition II WACC  declines at moderate debt level  increases at high debt level

M&M Case IIIProposition 1

M&M Case IIIProposition 2