1. Chapter 16 Financial Leverage and Capital Structure Policy
T Chapter Outline
Chapter 16 Financial Leverage and Capital Structure Policy
Chapter Organization
16.1 The Capital Structure Question
16.2 The Effect of Financial Leverage
16.3 Capital Structure and the Cost of Equity Capital
16.4 M&M Propositions I and II with Corporate Taxes
16.5 Bankruptcy Costs
16.6 Optimal Capital Structure
16.7 The Pie Again
16.8 Observed Capital Structures
16.9 A Quick Look at the Bankruptcy Process
16.10 Summary and Conclusions
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Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc. 2000

2. T16.2 What’s Your Financing I.Q.?
1. What do you need funding for?
a. To expand the business
b. To assist with business operations
c. To start the business
2. Describe your company’s profit history.
a. A steady upward climb
b. Even or flat, but steady
c. Inconsistent, or downward-sloping
3. How old is the business?
a. Three or more years
b. One to three years
c. Less than one year
4. How well known are you within your market?
a. Very well known
b. Somewhat known
c. Not known at all
5. Describe your company’s business plan.
a. Formal, complete, and current
b. Informal, but current
c. We have no formal business plan
6. How do you handle financial controls?
a. Formally
b. Some formally, some informally
c. There are no official controls in this area
7. What is your company’s ratio of assets to
liabilities, compared to your competitors?
a. Higher
b. Equal
c. Lower
8. For how many of these functions do you have
yourself: marketing, production, human
resources, office management, finance?
a. Almost all of them
b. Half of them
c. Two or less of them

3. T16.2 What’s Your Financing I.Q.? (concluded)
Scoring your business:
For each A answer, give yourself 10 points, 5 points for each B, and 0 points for each C.
60 points or above: It won’t take much to convince a lender that you’re worthy of financing.
points: You’re on the right track. Seek out lenders who are familiar with firms of your size and industry.
points: Obtain funds from government-subsidized programs such as the Small Business Administration (SBA).
Below 35: Take a close look at your company and consider making adjustments before you seriously consider seeking external financing.
Source: Adapted from : “What’s Your Financing I.Q?” Datamerge Corporation.

4. T16.3 Capital Structure, Cost of Capital, and the Value of the Firm
Key issues:
What is the relationship between capital structure and firm value?
What is the optimal capital structure?
Preliminaries:
Capital structure is flexible
Capital restructurings
Optimal capital structure: firm value vs. stock value
Optimal capital structure: firm value vs. WACC

5. T16.4 Example: Computing Break-Even EBIT
Ignoring taxes:
A. With no debt:
EPS = EBIT/500,000
B. With $2,500,000 in debt at 10%:
EPS = (EBIT - $______)/250,000
C. These are equal when:
EPSBE = EBITBE/______ = (EBITBE - $250,000)/250,000
D. With a little algebra:
EBITBE = $500,000
So EPSBE = $___ /share

6. T16.5 Financial Leverage, EPS and EBIT3
2.5 2
1.5 1
0.5
– 0.5
– 1
D/E = 1
D/E = 0
EBIT ($ millions, no taxes)

7. T16.6 Example: Homemade Leverage and ROE
Firm does not adopt proposed capital structure Investor puts up $500 and borrows $500 to buy 100 shares
EPS of unlevered firm $0.60 $1.30 $1.60
Earnings for 100 shares $60.00 $ $160.00
less interest on $500 at 10% $50.00 $50.00 $50.00
Net earnings $10.00 $80.00 $110.00
ROE 2% 16% 22%

8. T16.6 Homemade Leverage: An Example (concluded)
Firm adopts proposed capital structure Investor puts up $500, $250 in stock and $250 in bonds
EPS of levered firm $0.20 $1.60 $2.20
Earnings for 25 shares $5.00 $40.00 $55.00
plus interest on $250 at 10% $25.00 $25.00 $25.00
Net earnings $30.00 $65.00 $80.00
ROE 6% 13% 16%

9. T16.7 Milestones in Finance: The M&M Propositions
Financial leverage and firm value: Proposition I
Since investors can costlessly replicate the financing decisions of the firm (remember “homemade leverage”?), in the absence of taxes and other unpleasantries, the value of the firm is unaffected by its capital structure.
Corollary #1: There is no “magic” in finance - you can’t get something for nothing.
Corollary #2: Capital restructurings don’t create value, in and of themselves. (Why is the last part of the statement so important? Stay tuned.)

10. T16.7 Milestones in Finance: The M&M Propositions (concluded)
The cost of equity and financial leverage: Proposition II
A. Because of Prop. I, the WACC must be constant. With no taxes,
WACC = RA = (E/V)  RE + (D/V)  RD
where RA is the required return on the firm’s assets
B. Solve for RE to get MM Prop. II
RE = RA + (RA - RD)  (D/E)
( ) Cost of equity has two parts:
1. RA and “business” risk
2. D/E and “financial” risk

11. T16.8 The Cost of Equity and the WACC (Figure 16.3)
Cost of capital
RE = RA + (RA – RD ) x (D/E)
WACC = RA RD
Debt-equity ratio, D/E

12. T16.9 The CAPM, the SML, and Proposition II
The effect of financing decisions on firm risk is reflected in both M&M’s Proposition II and in the CAPM.
Consider Proposition II: All else equal, a higher debt-equity ratio will increase the required return on equity, RE.
M&M Proposition II: RE = RA + (RA - RD)  (D/E)
The effect of financing decisions is reflected in the equity beta, and, by the CAPM, increases the required return on equity.
CAPM: RE = RF + (RM - RF)  E
In other words, debt increases systematic risk (and moves the firm along the SML).

13. T16.10 Business Risk and Financial Risk
By M&M Proposition II, the required return on equity arises from two sources of firm risk. Proposition II is:
RE = RA + (RA - RD)  (D/E)
Business risk - equity risk that comes from the nature of the firm’s operating activities (measured by RA in the equation above); and
Financial risk - equity risk that comes from the financial policy (i.e., capital structure) of the firm. Financial risk is measured by (RA - RD)  (D/E) in the equation above.

14. T16.11 Debt, Taxes, Bankruptcy, and Firm Value
The interest tax shield and firm value
For simplicity: (1) perpetual cash flows (2) no depreciation (3) no fixed asset or NWC spending
A firm is considering going from zero debt to $400 at 10%:
Firm U Firm L (unlevered) (levered)
EBIT $200 $200
Interest 0 $40
Tax (40%) $80 $64
Net income $120 $96
Cash flow from assets $120 $____
Tax saving = $16 = ____  $40 = TC  RD  D

15. T16.11 Debt, Taxes, Bankruptcy, and Firm Value (concluded)
What’s the link between debt and firm value?
Since interest creates a tax deduction, borrowing creates a tax shield. Its value is added to the value of the firm.
MM Proposition I (with taxes)
PV(tax saving) = $16/____ = $____
= (TC  RD  D)/RD = TC D

16. T16.12 M&M Proposition I with Taxes (Figure 16.4)
Value of the firm (VL)
VL = VU + TC x D
= TC
TC x D
VL= $7,300
VU= $7,000 VU VU
Total debt (D)
$1,000

17. T16.13 Example: Debt, Taxes, and the WACC
Taxes and firm value: an example
EBIT = $100
TC = 30%
RU = 12.5%
Q. Suppose debt goes from $0 to $100 at 10%, what happens to equity value, E?
VU = $100  (______)/.125 = $560
VL = $  $_____ = $590, so E = $_____ .

18. T16.13 Example: Debt, Taxes, and the WACC (concluded)
WACC and the cost of equity (MM Proposition II with taxes)
With taxes:
RE = RU + (RU - RD)  (D/E)  (1 - TC )
RE = _____+ (_____- .10)  ($____/____)  ( )
= %
WACC = ($____/____)  (100/590)  .10  ( )
= %

19. T16.14 Taxes, the WACC, and Proposition II
Cost of capital (%) RE RU
WACC
RD  (1 – TC)
Debt-equity ratio, D/E

20. T16. 15 The Cost of Equity and the WACC: M&M Proposition II with Taxes
T The Cost of Equity and the WACC: M&M Proposition II with Taxes (Figure 16.5)
Cost of capital (%) RE
RE = 10.22%
RU = 10% RU
WACC = 9.6%
WACC
RD  (1 – TC)
= 8%  ( )
= 5.6%
RD  (1 – TC)
Debt-equity ratio, D/E

21. T16.16 Modigliani and Miller Summary (Table 16.6)
I. The No-Tax Case
A. Proposition I: The value of the firm levered equals the value of the firm unlevered:
VL = VU
Implications of Proposition I:
1. A firm’s capital structure is irrelevant.
2. A firm’s WACC is the same no matter what mix of debt and equity is used.
B. Proposition II: The cost of equity, RE, is
RE = RA + (RA - RD) D/E
where RA is the WACC, RD is the cost of debt, and D/E is the debt/equity ratio.
C. Implications of Proposition II
1. The cost of equity rises as the firm increases its use of debt financing.
2. The risk of equity depends on the risk of firm operations and on the degree of financial leverage.

22. T16.16 Modigliani and Miller Summary (Table 16.6) (concluded)
II. The Tax Case
A. Proposition I with Taxes:
The value of the firm levered equals the value of the firm unlevered plus the present value of the interest tax shield:
VL = VU + TcD
where Tc is the corporate tax rate and D is the amount of debt.
B. Implications of Proposition I:
1. Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is 100 percent debt.
2. A firm’s WACC decreases as the firm relies more heavily on debt financing.

23. T16.17 The Optimal Capital Structure and the Value of the Firm
Borrowing money is a good news/bad news proposition.
The good news: interest payments are deductible and create a “debt tax shield” (i.e., TCD).
The bad news: all else equal, borrowing more money increases the probability (and, therefore, the expected value) of direct and indirect bankruptcy costs.
Key issue: The Impact of Financial Distress on Firm Value
The Static Theory of Capital Structure
The theory that a firm borrows up to the point where the tax benefit from an extra dollar of debt is exactly equal to the cost that comes from the increased probability of financial distress.

24. T16.17 The Optimal Capital Structure and the Value of the Firm (continued) (Figure 16.6)
Value of the firm (VL )
VL = VU + TC  D
Present value of tax shield on debt
Financial distress costs
Maximum firm value VL*
Actual firm value VU
VU = Value of firm with no debt
Debt-equity ratio, D/E
D/E
Optimal amount of debt

25. D*/E* The optimal debt/equity ratio
T The Optimal Capital Structure and the Cost of Capital (Figure 16.7)
Cost of capital (%) RE RU RU
WACC
Minimum cost of capital
WACC*
RD  (1 – TC)
Debt/equity ratio (D/E)
D*/E* The optimal debt/equity ratio

26. T16.19 The Capital Structure Question (Figure 16.8)
Value of the firm ( VL )
Case II
M&M (with taxes)
VL*
PV of bankruptcy costs
Case III Static Theory
Net gain from leverage VU
Case I
M&M (no taxes)
Total debt (D) D*

27. T16.20 The Extended Pie Model (Figure 16.9)
Lower financial leverage
Higher financial leverage
Bondholder claim
Bondholder claim
Stockholder
claim
Bankruptcy claim
Stockholder
claim
Bankruptcy claim
Tax claim
Tax claim

28. T Chapter 16 Quick Quiz
1. Why does the firm’s cost of equity increase with leverage?
All else equal, as the D/E ratio increases, the riskiness of the remaining equity increases.
2. What are direct bankruptcy costs?
Direct bankruptcy costs are generally observable and, therefore, measurable. Examples: legal fees, accounting fees, administrative expenses.
3. What kinds of firms would be most likely to suffer indirect bankruptcy costs?
Firms most likely to lose customers and/or sales as the likelihood of distress increases.
4. Name three types of financial distress.
Business failure; legal bankruptcy; technical insolvency