1. Financial Leverage and Capital Structure Policy16
Financial Leverage and Capital Structure Policy

2. Chapter Outline The Capital Structure Question
The Effect of Financial Leverage
Capital Structure and the Cost of Equity Capital
M&M Propositions I and II with Corporate Taxes
Bankruptcy Costs
Optimal Capital Structure
The Pie Again
Observed Capital Structures

3. Capital Restructuring
We are going to look at how changes in capital structure affect the value of the firm, all else equal
Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets
The firm can increase leverage by issuing debt and repurchasing outstanding shares
The firm can decrease leverage by issuing new shares and retiring outstanding debt

4. Choosing a Capital Structure
What is the primary goal of financial managers?
Maximize stockholder’s wealth
We want to choose the capital structure that will maximize stockholder wealth
We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC

5. The Effect of Leverage
How does leverage affect the EPS and 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, then we pay our fixed cost and we have more left over for our stockholders.
If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders.
Leverage amplifies the variation in both EPS and ROE

6. Example: Financial Leverage, EPS and ROE – Part I
We will ignore the effect of taxes at this stage.
What happens to EPS and ROE when we issue debt and buy back shares of stock?
Click on the Excel icon to go to a spreadsheet that contains all of the information for the example presented in the instructors manual.

7. Capital Restructuring
Current Capital Structure
Proposed Capital Structure
Assets
$5,000,000
Debt $0
$2,500,000
Market Value of Equity
D/E 1
Outstanding Shares
500,000
250,000
Share Price
$10
Interest
N.A.
10%

8. Current Capital Structure: No Debt
Recession
Expected
Expansion
EBIT
$300,000
$650,000
$1,000,000
Interest
Net Income
ROE
6.00%
13.0%
20.0%
EPS
$0.6
$1.3
$2.0
Ex. ROE=300,000/5,000,000 =0.6
EPS= 300,000/500,000 = 0.6 ($)

9. Proposed Capital Structure: Debt=$2.5 million
Recession
Expected
Expansion
EBIT
$300,000
$650,000
$1,000,000
Interest
$250,000
Net Income
$50,000
$400,000
$750,000
ROE
2.00%
16.0%
30.0%
EPS
$0.2
$1.6
$3.00

10. Financial Leverage: EPS and EBIT

11. Example: Financial Leverage, EPS and ROE – Part II
Variability in ROE
Current: ROE ranges from 6% to 20%
Proposed: ROE ranges from 2% to 30%
Variability in EPS
Current: EPS ranges from $0.60 to $2.00
Proposed: EPS ranges from $0.20 to $3.00
The variability in both ROE and EPS increases when financial leverage is increased.

12. 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 stockholders.
If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders.

13. Example: Break-Even EBIT

14. Homemade Leverage
Individual investor can have the same leverage effect by borrowing money and buying stock.
The company does not have to change capital structure for a leverage effect.
Suppose that individual investors originally have 100 shares and no debt. Given that a stock price is $10, the market value of equity is equal to $1000.
Homemade leverage: Burrow $1000 and purchase additional 100 shares. Pay $100 as interest expenses.
10% interest rate is assumed.
TA for individual = $2,000 =200 shares x $10 per share
Equity =$1000, Debt=$1,000
D/E = 1

15. Example: Homemade Leverage and ROE
Recession
Expected
Expansion
No Debt
EPS =$ 0.6
EPS=$1.3
EPS=$2.0
D/E =1
EPS= $0.2
EPS=$1.6
EPS=$3.0
No leverage
(100 shares)
$60
$130
$200
$20
$160
$300
Homemade leverage
$120 - $100 =$20
$260-$100 =$160
$400-$100=$300
$0.6
$1.3
$2.0

16. Capital Structure Theory
The value of the firm is determined by the cash flows to the firm and the risk of the assets.
Changing firm value
Change the risk of the cash flows.
Change cash flows.
Modigliani and Miller Theory of Capital Structure
Proposition I – Firm value is independent of the firm’s capital structure.
Proposition II – WACC does not change and cost of equity increase with D/E.

17. Basic Assumption We only focus on OCF.
It is reasonable to assume that capital spending and working capital are not influenced by change in capital structure.
No depreciation because depreciation does not influence the firm’s value when D/E changes .
Leveraged OCF= (EBIT – Interests) (1-t) + Interests + Depreciation
Unleveraged OCF= (EBIT- 0) (1-t)+ Deprecation
Leveraged OCF – Unleveraged OCF = t * Interests

18. Capital Structure Theory Under 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

19. Case I – Propositions I and II
MM 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.
MM Proposition II
The WACC of the firm is NOT affected by capital structure.
Cost of equity is increased by increasing D/E.
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.

20. 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.
The risk of assets is independent of capital structure.
(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.
When D=0, RE is called as Ru where unleveraged firm’s cost of capital.

21. Figure 16.3

22. Case I - Example
Information: Required return on assets = 16%, cost of debt = 10%; percent of debt to firm’s value = 45%
What is the cost of equity?
RE = 16 + ( )(.45/.55) = 20.91%
Suppose instead that the percent of debt =60%. What is the cost of equity?
RE = 16 + ( )(.6/.4) = 16+9 =25
Based on this information, how can you describe the relation between the cost of equity and the debt –equity ratio?
As the debt-equity ratio increases, the cost of equity increases.

23. The CAPM, the SML and Proposition II
How does financial leverage affect the systematic risk?
CAPM: E(RA )= Rf + A(E(RM)– Rf)
Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets.
WACC = RA = (E/V)RE + (D/V)RD
Replace returns of equity and debt with the CAPM
A= (E/V) E + (D/V) D

24. Business Risk and Financial Risk
E = A+ (A - D)D/E
Therefore, the systematic risk of the stock depends on:
Systematic risk of the assets, A, (Business risk)
Level of leverage, D/E, (Financial risk)
In case 1 (no taxes and no bankruptcy costs)
MM proposition I and II hold.
Cost of equity increases by D/E.
Systematic risk of equity increases by D/E.
Point out once again that this result assumes that the debt is risk-free. The effect of leverage on financial risk will be even greater if the debt is not default free.

25. Case II – Cash Flow Interest is tax deductible.
Therefore, when a firm adds debt, it reduces taxes, all else equal.
The reduction in taxes increases the cash flow of the firm.
How should an increase in cash flows affect the value of the firm?
Assume that the market value of Debt is $6,250 and annual interest rate is 8%.
Point out that the government effectively pays part of our interest expense for us; it is subsidizing a portion of the interest payment.

26. Case II - Example Unlevered Firm Levered Firm EBIT 5000 Interest 500
500
Taxable Income
4500
Taxes (34%)
1700
1530
Net Income
3300
2970
OCF
3470
The levered firm has $6250 of debt with 8% cost of debt. 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)
We do not consider depreciation because it does not affect the result.

27. Interest Tax Shield Annual interest tax shield
Tax rate times interest payment
$6,250 in 8% debt = $500 in interest expense
Assume that coupon rate is equal to YTM.
Annual tax shield = .34(500) = 170
Present value of annual interest tax shield
Assume perpetual debt for simplicity
PV = 170 / .08 = 2125
PV = D(RD)(TC) / RD = D TC = 6250(.34) = 2125
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.

28. 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
Assuming perpetual cash flows (EBIT (1-T))
VU = EBIT(1-T) / RU, RU is the cost of capital for the unleveraged firm.
VL = VU + DTC , DTC = D(RD)(TC) / RD =D Tc
RU is the cost of capital for an unlevered firm = RA for an unlevered firm
VU is jus the PV of the expected future cash flow from assets for an unlevered firm.

29. Example: Case II – Proposition I
EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%
EBIT and Debt are assumed to be perpetual.
VU = 25(1-.35) / .12 = $ million
VL = (.35) = $ million
E = – 75 = $86.67 million
Firm value increases by D/E, violating MM proposition I.

30. Figure 16.4

31. 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) --(1)
RA =RU [1-TC (D/V)] = RU [E+(1-TC)D]/V, ---(2)
RU is the cost of capital for unleveraged firm (all equity financed firm)
RA is the cost of capital (WACC) for leveraged firm.
[ Equation (2) comes from (VL = VU + DTC )].
RE = RU + (RU – RD)(D/E)(1-TC), by using (1) and (2).
Example (RU = 12, RD= 9), what is the leveraged firm’s cost of equity and WACC?
RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35) RA = 10.05%
We define Ru as cost of capital for a unleveraged firm. EBIT(1-T)/ Vu =Ru
VL = EBIT (1-T)/Ru +DT -> VL = [EBIT(1-T)+D T Ru]/Ru -> Ru = [EBIT(1-T)+DT Ru]/ VL ---
(4). Rearranging equation (4), Ru – (D/VL) T Ru = EBIT(1-T)/ VL , EBIT(1-T)/ VL =RA = Ru(1-(D/VL)T)
For EBIT(1-T)/ VL =RA , although tax benefits are real cash flows benefit, we reduce the cost of capital instead of increasing cash flows. In other words, EBIT (1-T) are assumed to be same for all equity financed firm and leveraged firm. However, the cost of capital for all equity financed firm = EBIT(1-T)/Vu = Ru
The cost of capital for leveraged firm = EBIT(1-T)/ VL = RA = Ru(1-(D/V)T)

32. Example: Case II – Proposition II
EBIT = 25 million; Tax rate = 35%; Cost of debt = 9%; Unlevered cost of capital = 12%
EBIT and Debt are assumed to be perpetual.
VL = (.35) = $ million, if D=75
Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1.
D/E =1
VL = Vu + D t = $ D (0.35) = E + D = 2 D
D = = E
VL = (2) =
Since D/E increases, the firm’s value increases.
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.

33. WACC and the firm’s value
What will happen to the cost of equity under the new capital structure? (RU = 12, RD= 9)
RE = 12 + (12 - 9)(1)(1-.35) = 13.95%
What will happen to the weighted average cost of capital?
RA = .5(13.95) + .5(9)(1-.35) = 9.9%
VL = EBIT (1-t) / RA = 25 (1-0.35)/0.099 =
VL = EBIT (1-t)/Ru + D t = Vu + D t = EBIT (1-t)/RA
When WACC is used, OCF should not consider tax shields of interests because the discount rate of WACC already considers tax shield .

34. Figure 16.5

35. Case III Now we add bankruptcy costs
As the D/E ratio increases, the probability of bankruptcy increases.
This increased probability will increase the expected bankruptcy costs.
At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost.
At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added.
Note that we are talking about “expected” in a statistical sense. If the firm goes bankrupt – it will have a certain level of costs it will incur. If the firm is all equity financed, then the expected bankruptcy cost is 0 since the probability of bankruptcy is 0. As the firm adds debt the probability of incurring the bankruptcy costs increases and thus the expected bankruptcy cost increases.

36. Bankruptcy Costs Financial distress Direct costs
Significant problems in meeting debt obligations.
Most firms that experience financial distress do not ultimately file for bankruptcy.
Direct costs
Legal and administrative costs
Ultimately cause bondholders to incur additional losses
Disincentive to debt financing

37. More Bankruptcy Costs Indirect bankruptcy costs
Larger than direct costs, but more difficult to measure and estimate
Stockholders want to avoid a formal bankruptcy filing.
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.
The firm may also lose sales, experience interrupted operations and lose valuable employees.

38. Figure 16.6

39. Figure 16.7

40. Figure 16.8

41. Conclusions Case I – no taxes or bankruptcy costs
No optimal capital structure
Case II – corporate taxes but no bankruptcy costs
Optimal capital structure is almost 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 a certain combination of debt and equity.
Occur where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs.

42. Figure 16.9

43. The Total Value of the Firm
Total value of the firm = marketed claims + non-marketed claims
Marketed claims are the claims of stockholders and bondholders.
Non-marketed claims are the claims of the government and other potential stakeholders.
The overall value of the firm is unaffected by changes in capital structure.
The division of value between marketed claims and non-marketed claims may be impacted by capital structure decisions.

44. Observed Capital Structure
Capital structure does differ by industries.
Differences according to Cost of Capital 2000 Yearbook by Ibbotson Associates, Inc.
Lowest levels of debt
Drugs with 2.75% debt
Computers with 6.91% debt
Highest levels of debt
Steel with 55.84% debt.
Department stores with 50.53% debt.
See Table 13.5 in the book for more detail

45. Announcement of Debt Issues
Stock price normally increases when a company announces unexpected debt issue.
Good news to the company who will issue debt.
This is not because of expected tax benefits but because of asymmetric information between the company and investors.
Why?
Signaling Hypothesis
The market interprets debt issue announcement as good news because investors expect that the company will have enough earnings in the future to cover the debt burden. -> The company has confidence about future earnings.
Misvaluation hypothesis
The company knows about valuation of its stock. When it believes that its stock is undervalued. It prefers debt to equity.

46. Announcement of Equity Issues
It is exactly opposite to debt issues.
Stock price normally decreases when the company unexpectedly announces equity issues.
Why?
Signaling Hypothesis
The market interprets equity issue announcement as bad news because investors expect that the company will have enough earnings in the future to cover the debt burden. -> The company has confidence about future earnings.
Misvaluation hypothesis
The company knows about valuation of its stock. When it believes that its stock is overvalued. It prefers debt to equity

47. Pecking Order Theory Pecking order theory
 Use internal financing first
Issue debt next
new equity last
Pecking order theory is based on asymmetric information about valuation of stock.
Since the effect of equity announcement on stock price is negative, the company does not like issue equity.
 The pecking-order theory is in contrast to the optimal capital structure theory
there is no target D/E ratio
profitable firms will use less debt

48. Quick Quiz Explain the effect of leverage on EPS and ROE
How do we determine the optimal capital structure?
What is the optimal capital structure in the three cases that were discussed in this chapter?
What is the pecking order theory?
Effect of debt or equity announcement on stock price

49. 16
End of Chapter