1. Financial Leverage and Capital Structure Policy
Chapter 16

2. Capital Restructuring
What is meant by capital restructuring
What is the primary goal of financial managers?
Can leverage help in achieving such goals?

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 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. Financial Leverage The extent to which a firm relies on debt
The more debt financing a firm uses in its capital structure, the more financial leverage it employs

6. Financial leverage, EPS, and ROE: an example
proposed
current
8,000,000
Asset
4,000,000
debt
Equity 1
Debt-equity ratio 20
Share price
200,000
400,000
Shares out standing
10%
Interest rate

7. Financial leverage, EPS, and ROE: an example
Current capital structure : No Debt
expansion
expected
Recession
1,500,000
1,000,000
500,000
EBIT
Interest
Net income
18.75%
12.5%
6.25%
ROE
3.75
2.5
1.25
EPS
Proposed capital structure : debt= 4$ million
400,000
1,100,000
600,000
100,000
27.5%
15%
2.5%
5.5 3
0.5$

8. 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

9. Ex 1 Page 540
Maynard, Inc., has no debt outstanding and a total market value of 250,000$. EBIT are projected to be 28,000$ if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 50 percent lower. Maynard is considering a 90,000$ debt issue with a 7 percent interest rate. The proceeds will be used to repurchase a share of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem
Calculate EPS under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession.
Repeat part (a) assuming that the economy goes with recapitalization. What do you observe?

10. Ex 4 Page 542
James Corporation is comparing two different capital structures: an all equity plan (plan I) and a levered plan (plan II). Under plan I, the company would have 160,000 shares of stock outstanding. Under plan II, there would be 80,000 shares of stock outstanding and 2.8$ million in debt outstanding. The interest rate on the debt is 8 percent and there are no taxes.
If EBIT is 350,000$, which plan will result in the higher EPS?
If EBIT is 500,000$, which plan will result in the higher EPS?
What is the break-even EBIT?

11. Corporate borrowing & home made leverage
The effect of leverage depends on the company’s EBIT. When EBIT is relatively high, leverage is beneficial
Under the expected scenarios, leverage increase the returns to shareholders, as measured by both ROE and EPS
Shareholders are exposed to more risk under the proposed capital structure because the EPS and ROE are much more sensitive to changes in EBIT in this case
Because of the impact that financial leverage has on both the expected return to stockholder and the riskiness of the stock, capital structure is an important consideration

12. Corporate borrowing & home made leverage
Homemade leverage: the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.

13. Corporate borrowing & home made leverage
Proposed capital structure
expansion
expected
recession
5.5$ 3$
0.5$
EPS
550
300 50
Earnings for 100 shares
Original capital structure and homemade leverage
3.75
2.5
1.25
750
500
250
Earnings for 200 shares
200
Less: interest on $2,000 at 10%
Net earnings

14. Ex 9 Page 543
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with 600,000$ in stock. XYZ uses both stock and perpetual debt; its stock is worth 300,000$ and the interest rate on its debt is 8 percent. Both firms expect EBIT to be 80,000$
Rico owns 30,000$ worth of XYZ’s stock. What rate of return is he expecting?
Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage?

15. Capital Structure Theory
Modigliani and Miller (M&M)Theory of Capital Structure
Proposition I: the value of the firm is independent of the firm’s capital structure
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 (THE PIE MODEL)

16. Capital Structure Theory
Proposition II
The firm’s cost of equity capital is a positive linear function of the firm’s capital structure
RE = RA + (RA – RD)(D/E)
The cost of equity depends on three things
The WACC of the firm is NOT affected by capital structure

17. Capital Structure Theory

18. Example What is the cost of equity?
Required return on assets = 16%; cost of debt = 10%; debt=45%
What is the cost of equity?
Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio?
Based on this information, what is the percent of equity in the firm?

19. M & M proposition I and II with corporate taxes
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?

20. M & M proposition I and II with corporate taxes
Firm L
Firm U
1,000
EBIT 80 I
920
Taxable income
276
300
Taxes (30%)
644
700 NI

21. M & M proposition I and II with corporate taxes
Firm L
Firm U
CFFA
1,ooo
EBIT
276
300
Taxes
724
700
total
Firm L
Firm U
Cash flow
644
700
To stock holder 80
To bond holder
724
total

22. M & M proposition I with taxes

23. M & M proposition I and II with corporate taxes
Interest tax shield: the tax saving attained by a firm from interest expense
Proposition I with taxes:
Value of a levered firm = value of an unlevered firm + PV of interest tax shield
VL = VU + DTC

24. Example
EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%
Calculate the PV of VU, VL?

25. Proposition II with taxes

26. Ex 10 Page 543
Wood Crop. Uses no debt. The WACC is 9 percent. If the current market value of the equity is 23$ million and there are no taxes, what is EBIT?

27. Ex 11 Page 543
In the previous question suppose that corporate tax rate is 35 percent. What is EBIT? What is the WACC? Explain?

28. Ex 14 Page 543
Frederick & Co. expects its EBIT to be 92,000$ every year for ever. The firm can borrow at 9 percent. Frederick currently has no debt, and its cost of equity is 15 percent. If the tax rate is 35 percent, what is the value of the firm? What will the value be if the company borrows 60,000$ and uses the proceeds to repurchase shares?

29. Ex 15 Page 544
In problem 14, what is the cost of equity after recapitalization? What is the WACC? What are the implications for the firm’s capital structure decision?

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

31. 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

32. Optimal Capital Structure
The static theory of capital structure:

33. Optimal Capital Structure and the cost of capital

35. 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 is just offset by the increase in expected bankruptcy costs

36. Managerial recommendations
Taxes
Financial distress