0. Week 10 Lecture 10 Ross, Westerfield and Jordan 7e Chapter 17
Financial Leverage and
Capital Structure Policy

1. Last Lecture.. Cost of Equity Cost of Preferred Stock Cost of Debt
Proportion or weight of each form of financing
Cost of Capital = WACC
Unadjusted/Adjusted
When should we use WACC?
Other approaches: pure play and subjective
Flotation Costs

2. Chapter 17 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

3. Choosing a Capital Structure
What is the primary goal of financial managers?
Maximize stockholder wealth
Choose the optimal capital structure
Maximize the value of the firm
Minimize the WACC

4. Capital Restructuring
Financial leverage = the extent to which a firm relies on debt financing
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

5. The Effect of Leverage
How does leverage affect the EPS and ROE of a firm?
More debt financing, means more fixed interest expense
In expansion, we have more income after we pay interest, have more left over for stockholders
In recession, we still have to pay our costs therefore we have less left over for stockholders
Leverage amplifies the variation in both EPS and ROE

6. Example: Financial Leverage, EPS and ROE

7. Break-Even EBIT Break-Even EBIT where: EPS debt = EPS no debt
If expected EBIT > break-even EBIT, then leverage is beneficial to our stockholders
If expected EBIT < break-even EBIT, then leverage is detrimental to our stockholders

8. Example: Break-Even EBIT
Numbers in thousands
EPS with No Debt = $500/500 = $1
EPS with Debt = ($500-$250)/250 = $1

9. Break Even EBIT
With debt
With no debt

10. Capital Structure Theory
Modigliani and Miller Theory of Capital Structure
Proposition I – firm value
Proposition II – cost of equity & WACC
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 the cash flows

11. Capital Structure Theory Under Three Special Cases
Case I – Assumptions
No taxes
No bankruptcy costs
Case II – Assumptions
With taxes
Case III – Assumptions
With bankruptcy costs

12. Case I – No Taxes Proposition I Proposition II
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
Proposition II
Cost of Equity increases as Debt increases
The WACC of the firm is NOT affected by capital structure

13. Case I - No Taxes - 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
(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

14. Figure 17.3

15. Case I - No Taxes - Example
Data
Required return on assets = WACC = RA = 16%,
Cost of debt = RD = 10%
Percent of debt = D = 45%
E = = 0.55 or 55%
D/E = 0.45/0.55 = 0.82
What is the cost of equity?
RE = RA + (RA – RD)(D/E)
RE = (0.16 – 0.10)(.45/.55) = 20.91%
Proof for WACC:
WACC = RA = (E/V)RE + (D/V)RD
WACC = RA = 0.55 * 20.91% * 10% = 16%

16. Case I – No Taxes Example continued..
What happens if the firm increases leverage so that D/E = 1.5? (before D/E = 0.82 when D=45%,E=55%)
What is the cost of equity?
RE = RA + (RA – RD)(D/E)
RE = (0.16 – 0.10)(1.5) = 0.25 or 25%
Proof for WACC:
WACC = RA = (E/V)RE + (D/V)RD
From D/E = 1.5, D = 60%, E = 40%
WACC = 0.4 * 25% * 10% = 16%

17. The CAPM, Business Risk, Financial Risk and Proposition II
How does financial leverage affect systematic risk?
CAPM: RE = Rf + E(RM – Rf) – for equity
CAPM: RA = Rf + A(RM – Rf) – for assets
Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets, also called unleverred beta – the risk of the assets if the firm would have no debt ( in essence E = A if no debt)
RE = RA + (RA – RD)(D/E)
RE = RA + (RA – Rf)(D/E) - assume RD = Rf
Proposition II
As we introduce debt in the firm:
RE = Rf + A(1+D/E)(RM – Rf)
E = A(1 + 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)

18. Case II – Introducing Taxes
What happens to the firm’s cash flows?
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?

19. Case II - with Taxes - Example
Unlevered Firm
No Debt
Levered Firm
With Debt
EBIT
5000
Interest
Taxable Income
4500
Taxes (34%)
1700
1530
Net Income
3300
2970
CFFA
3470

20. Interest Tax Shield Annual interest tax shield
Tax rate times interest payment
6250 in 8% debt = 500 in interest expense
Annual tax shield = 0.34(500) = 170
Present value of annual interest tax shield
Assume perpetual debt for simplicity
PV = 170 / 0.08 = 2125

21. Case II - with Taxes - 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
VU = EBIT(1-T) / RU
with no debt RU = RA= RE and VU = E
VL = VU + D*TC
E = VL - D

22. Case II – with Taxes Proposition I - Example
Data Inc. has earnings of 25 million per year every year. The firm has no debt and the cost of capital is 12%. If tax is 35% what is the value of the firm?
EBIT = 25 million; Tax rate = TC= 35%;
Unlevered cost of capital = RU= 12% = RA = RE
VU = ?
VU = EBIT(1-T) / RU
VU = 25(1-0.35) / 0.12 = $ million
VU = E

23. Case II – with Taxes Proposition I - Example (cont.)
Data Inc. decides to issue bonds that have a market value of 75 million at a cost of 9%. What is the value of the firm? What will be the value of equity?
D = $75 million, RD= 9%, VL = ?, E = ?
VU = (calculated on previous slide)
VL = VU + tax shield
VL = VU + D*TC
VL = (0.35) = $ million
E = VL - D
E = – 75 = $86.67 million

24. Figure 17.4 Case II - with Taxes Proposition I

25. Case II – with Taxes - Proposition II
Recap: In case I – Proposition II - no taxes:
RE increases as Debt increases
WACC is unchanged
When taxes are introduced in Case II:
RE = RU + (RU – RD)(D/E)(1-TC)
WACC decreases as D/E increases because the cost of debt decreases
RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)

26. Case II – with Taxes Proposition II - Example
Data Inc. info from Case II proposition I:
EBIT = 25 million; TC= 35%; D = $75 million;
RD= 9%; Unlevered cost of capital = RU= 12%
E = $86.67m; VL = $161.67m
D/E = 75/86.67 = 0.87,
E/V = 86.67/ = 0.54,
D/V = 75/ = 0.46
RE = RU + (RU – RD)(D/E)(1-TC)
RE = ( )(0.87)(1-0.35) = 13.69%
RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)
RL = WACC = (0.54)(0.1369) + (0.46)(0.09)(1-.35) = 10.05%

27. Example: Case II – Proposition II
Suppose Data Inc. changes its capital structure so that the debt-to-equity ratio becomes 1.
Before: D/E = 0.87, E= 54%, D=46%
Now: D/E = 1, E= 50%, D=50%
What will happen to the cost of equity under the new capital structure? (previously 13.69%)
RE = (0.12 – 0.09)(1)(1-0.35) = 13.95%
What will happen to the weighted average cost of capital? (previously 10.05%)
WACC = 0.5(0.1395) + 0.5(0.09)(1-0.35) = 9.9%
What if D/E = 1.25?, RE = ?, WACC = ?

28. Figure 17.5 - Case II with Taxes Proposition II

29. Case III – with Bankruptcy Costs
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

30. Figure 17.6 – Case III with Bankruptcy costs

31. Figure 17.7 Case III with Bankruptcy costs

32. Bankruptcy Costs Direct costs Indirect costs Financial distress costs
Legal and administrative costs
Indirect costs
Larger than direct costs & more difficult to measure and estimate
Financial distress costs
All costs associated with going bankrupt and/or avoiding bankruptcy

33. 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 part debt and part equity
Occurs where the benefit from an additional dollar of debt just offsets the increase in expected bankruptcy costs

34. Figure 17.8

35. Managerial Recommendations
The tax benefit is only important if the firm has a large tax liability
Risk of financial distress
The greater the risk of financial distress, the less debt will be optimal for the firm
The cost of financial distress varies across firms and industries and as a manager you need to understand the cost for your industry

36. End Chapter 17