1. Copyright: M. S. Humayun1 Financial Management Lecture No. 32 Financial Leverage & Introduction to Capital Structure Theory

2. Copyright: M. S. Humayun2 Recap of WACC, Business Risk, & Leverage WACC % = r D X D + r E X E + r P X P. (Debt,Common Equity, Preferred Equity) –Where “r” is ACTUAL COST which can be calculated from REQUIRED ROR after accounting for Taxes & Transaction Costs. –Equity Capital: If Not Enough Retained Earnings then Equity Capital must be financed by New Stock Issuance which is more costly. Total Risk Faced by FIRM –Total Risk = Business Risk + Financial Risk Standard Deviation of ROE (Levered Firm ABC) = Standard Deviation (if Firm ABC is Un-Levered) + Financial Risk (from Debt) –Business Risk (from Operations except Debt) Uncertainty & Fluctuations in Prices & Costs. Specific & Market Causes. Higher Operating Leverage (OL = Fixed Costs / Total Costs) –Higher Mean ROE WHEN FIRM’S SALES > BREAKEVEN POINT –Higher Fixed Costs means Higher Breakeven Point and More Chances of Operating Loss. Risk of Large Drop in Return on Equity so Higher Risk. –Financial Risk (from Debt, Bonds, or Loan) Created when you take Loan or Debt or Financial Leverage (FL = Debt / (Debt + Equity) Financial Risk = Std Dev of ROE (Levered) - Std Dev of ROE (Un-levered) –Example: If Total Risk = 30% and Business Risk = 20% then Financial Risk = 30% - 20% = 10%

3. Copyright: M. S. Humayun3 SML – WACC Graph SML Line (EXTERNAL MARKET criterion) Firm’s own WACC (INTERNAL criterion) Required ROR rCE (%) Beta Risk rRF = T- Bill rate WACC FEASIBLE REGION (where IRR of investment or project is more than SML and WACC)

4. Copyright: M. S. Humayun4 Financial Leverage Concept Created when you take Loan or Debt or Financial Leverage (FL). Financial Leverage (%) =Debt /Total Assets =D/A = Debt / Debt + Equity = D / (D+E) If Firm has Rs 1000 of Total Assets and Rs 500 Debt then it has 50% (=50/1000) Financial Leverage Practically, Firms increase Financial Leverage by: –Issuing New Debt (ie. Taking New Loans and Increase Debt) OR –Replacing Equity with New Debt ( Increasing Debt AND DECREASING EQUITY too)

5. Copyright: M. S. Humayun5 Financial Leverage Impact on Risk & Return of Firm Financial Leverage (or Debt Financing) Generally Increases Overall Risk & Return of a Firm: Increases Return (Mean ROE): –When EBIT /Total Assets > Interest Cost then Financial Leverage is Good. Small Increase in EBIT can create much LARGER Increase in ROE. –If Equity (and number of shares) Reduced then Return (NI) per Share Increases Increases Risk (Standard Deviation in ROE): Fixed Interest Dues so Higher Chances of Losses, No Dividends for Shareholders. Possibility of Large Drop in ROE. Possibly Default. More Risk Transferred to Stockholders. –If Equity (and number of shares) Reduced then Risk per Share Increases.

6. Copyright: M. S. Humayun6 Financial Leverage ROE Volatility & Risk EBITInterestEBTTaxNet Income ROE (Rs50)(30%) (=NI/Equity) Un-Levered6000600180420 42% 300030090210 21% 500501535 3.5% Levered60050550165385 77% 3005025075175 35% 5050000 0% Leverage (or Debt) Increases the Spread or Range of Possible ROE thereby Increasing Uncertainty and Risk.

7. Copyright: M. S. Humayun7 Visualizing Financial Leverage (FL) Impact on ROE & Capital Structure LEVERED (Debt & Equity) Firm: Higher Slope. ROE more sensitive to changes in EBIT UN-LEVERED (100% Equity) Firm. Safer Capital Structure at Low EBIT’s EBIT (Rs) ROE (%) 21% = UL 35% = L 300 77% 60050 42% 3.5% 0%

8. Copyright: M. S. Humayun8 Visualizing Impact of Financial Leverage on ROE & Capital Structure Un-Levered (100% Equity): Lower ROE and Lower Risk. Levered (Debt & Equity): Higher ROE but Higher Risk Probability (p) Return on Equity ( ROE)% Risk Mean ROE Levered = 35% Mean ROE Un-Levered = 21%

9. Copyright: M. S. Humayun9 Capital Structure Theory Financial Leverage (FL = D / (D+E)): –Increases Overall Return (Mean ROE) when EBIT/Total Assets > Interest (or Cost of Debt then Leverage is Good because small Increase in EBIT causes much LARGER Increase in ROE. –Increases Overall RISK (Standard Deviation of ROE) of FIRM. Leverage will always MAGNIFY or AMPLIFY a small change in EBIT into a LARGER change in ROE. Fundamental Principle in Risk-Return: Rational Investors in Efficient Markets will only take Extra Risk if they are Compensated by Sufficient Extra Return. Should the Management of a Firm undertake Financial Leverage? If So, then how much Debt should a Firm have? –Answer provided by Capital Structure Theory

10. Copyright: M. S. Humayun10 Modigliani - Miller: Fathers of Corporate Finance “Cost of Capital, Corporate Finance, and The Theory of Investment” - Revolutionary Article Published by Professors Modigliani & Miller in American Economic Review in June 1958. Won Nobel Prize. “Pure M-M” (or Modigliani-Miller) Model - IDEAL CASE: –Major Assumptions: No Taxes, No Bankruptcy Costs, Efficient Markets, Equal Information Available to All Investors –Major Conclusions: Capital Structure has NO AFFECT on VALUE of a FIRM ! Capital Structure is Irrelevant ! It does NOT matter how a firm finances its operations, how much debt it has because is has NO bearing on a Firm’s Overall Value as calculated using NPV ! Corporate Financing & Capital Structure Decisions have no bearing on Investment (or Capital Budgeting) Decisions. Capital Budgeting can be carried out without knowing the exact Capital Structure of a Firm - you can assume 100% Equity (Un-levered) Firm.

11. Copyright: M. S. Humayun11 Modified MM - With Taxes Modigliani-Miller (With Corporate Tax) –In most countries, a FIRM’s Interest Payments to Bond Holders are NOT Taxed. But Dividend Payments to Equity Holders are Taxed. –Based on CORPORATE TAXES, FIRMS should prefer to raise Capital using DEBT Financing. Merton-Miller (With Personal Tax) –In most countries, INVESTORS pay a higher Personal Income Tax on Interest Income from Bonds than on Dividend Income from Equity (or Stocks). –Based on PERSONAL TAXES, INVESTORS should prefer to invest in STOCKS (or Equity). Uncertain Conclusion: Difficult to determine Net Effect. But, practically speaking, Corporate Tax Effect is generally stronger so Based on Taxes alone, Firms should prefer Debt.