1. Chapter 12: Leverage and Capital Structure

2. Capital structure decision
Capital structure decisions: The decisions about a firm’s debt-equity ratio
How should a firm choose its debt-equity ratio?
Guiding principle: Choose a ratio that maximize the value of the firm
The value of the firm is maximized when the WACC (discount rate for the firm’s future cash flows) is minimized
Optimal capital structure or target capital structure is one that minimizes its WACC

3. The effect of financial leverage
Financial leverage refers to the extent to which a firm relies on debt
How financial leverage works?

4. 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
Remind the students that if we increase the amount of debt in a restructuring, we are implicitly decreasing the amount of outstanding shares.
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5. Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering going into debt. (Issue debt to buy back stock.)
Proposed
$20,000
$8,000
$12,000
2/3 8%
240
$50
Current
Assets $20,000
Debt $0
Equity $20,000
Debt/Equity ratio 0.00
Interest rate n/a
Shares outstanding 400
Share price $50
The firm borrows $8,000 and buys back 160 shares at $50 per share.

6. EPS and ROE Under Current Capital Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares

7. EPS and ROE Under Proposed Capital Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 1.8% 6.8% 11.8%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares

8. EPS and ROE Under Both Capital Structures
All-Equity Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
Levered Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 1.8% 6.8% 11.8%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares

9. Financial Leverage and EPS
12.00
Debt
10.00
8.00
No Debt
6.00
Advantage to debt
Break-even point
EPS
4.00
2.00
0.00
1,000
2,000
3,000
Disadvantage to debt
(2.00)
EBIT
EBI in dollars, no taxes

10. 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 may be beneficial to our stockholders
If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders
Lecture Tip: Many students feel that if a company expects to achieve the break-even EBIT, it should automatically issue debt. You should emphasize that this is a break-even point relative to EBIT and EPS. Beyond this point, EPS will be larger under the debt alternative, but with additional debt, the firm will have additional financial risk that would increase the required return on its common stock. A higher required return might offset the increase in EPS, resulting in a lower firm value despite the higher EPS. The M&M models, described in upcoming sections, will offer key points to make about this relationship.
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11. Break-even EBIT
You are considering two different capital structures. The first option consists of 20,000 shares of stock. The second option consists of 10,000 shares of stock plus $200,000 of debt with an interest rate of 8%. Ignore taxes.
What is the break-even level of EBIT between these two options?

12. Break-even EBIT

13. Homemade Leverage
The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed
Investors can always increase financial leverage themselves
It makes no difference to investors whether or not companies change capital structures

14. Homemade Leverage: An Example
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $100 $200 $300
Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3% 11% 20%
We are buying 40 shares of a $50 stock on margin. We get the same ROE as if we bought into a levered firm.
Our personal debt equity ratio is:

15. Homemade (Un)Leverage: An Example
Recession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236
ROE (Net Profits / $1,200) 3% 11% 20%
Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm.
This is the fundamental insight of M&M

16. Homemade leverage
ABCO, Inc. has EBIT of $100,000. There are 50,000 shares of stock outstanding at a market price of $20 a share. ABCO has just decided to issue $400,000 of debt at a rate of 8% to repurchase shares of stock. Fred owns 20,000 shares of ABCO stock. Fred wants to use homemade leverage to offset the leverage being assumed by ABCO.
How many shares of ABCO stock must Fred sell to achieve his goal if he loans out the funds from the stock sale at 8% interest?

17. Homemade leverage No Debt Debt EBIT $100,000 $100,000
Interest ______ ?
Net income $100, ?
# of shares , ?
EPS $ ?

18. Homemade leverage

19. Homemade leverage No Debt Debt EBIT $100,000 $100,000
Interest ,000
Net income $100, $ 68,000
# of shares , ,000
EPS $ $2.2667

20. Homemade leverage Unlevered: 20,000 shares  $2.00 = $40,000 Levered:

21. Homemade leverage Weights Stock: 30,000  $20 = $ 600,000 60%
Debt: = $ 400, %
Total: $1,000, %

22. Homemade leverage Investment = 20,000  $20 = $400,000 Stock:
60% of $400,000 = $240,000
$240,000  $20 = 12,000 shares
Loan out:
40% of $400,000 = $160,000

23. Homemade leverage No company debt and no homemade leverage:
20,000 shares  $ = $40,000
Homemade leverage used to offset firm leverage:
Stock: 12,000  $ = $27,200
Loan: $400,000  = $12,800
Total: $40,000

24. Assumptions of the Modigliani-Miller Model
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:
Perfect competition
Firms and investors can borrow/lend at the same rate
Equal access to all relevant information
No transaction costs
No taxes

25. The MM Propositions I & II (No Taxes)
Proposition I
Firm value is not affected by leverage
VL = VU
Proposition II
Leverage increases the risk and return to stockholders
rE = r0 + (D / EL) (r0 - rD)
rD is the interest rate (cost of debt)
rE is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
D is the value of debt
EL is the value of levered equity

26. The MM Proposition I (No Taxes)
The derivation is straightforward:
The present value of this stream of cash flows is VL
The present value of this stream of cash flows is VU

27. The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes
Cost of capital: r (%) r0 rB rD
Debt-to-equity Ratio

28. M&M Proposition I, no tax
A debt-free firm currently has 400,000 shares of stock outstanding. The company is considering reducing the number of shares to 300,000. To do this, the firm will have to borrow $5 million at 8% interest.
Ignoring taxes, what is the value of the firm?

29. M&M Proposition I, no tax

30. M&M Proposition II, no tax
Walter’s Store has a debt/equity ratio of .60. The required return on assets is 12% and the pre-tax cost of debt is 8%. Ignore taxes.
What is the cost of equity?

31. M&M Proposition II, no tax

32. The MM Propositions I & II (with Corporate Taxes)
Proposition I (with Corporate Taxes)
Firm value increases with leverage
VL = VU + TC D
Proposition II (with Corporate Taxes)
Some of the increase in equity risk and return is offset by interest tax shield
rE = r0 + (D/E)×(1-TC)×(r0 - rD)
rD is the interest rate (cost of debt)
rE is the return on equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
D is the value of debt
E is the value of levered equity

33. The MM Proposition I (Corp. Taxes)
The present value of this stream of cash flows is VL
The present value of the first term is VU
The present value of the second term is TCD

34. The MM Proposition II (Corp. Taxes)
Start with M&M Proposition I with taxes:
Since
The cash flows from each side of the balance sheet must equal:
Divide both sides by S
Which quickly reduces to

35. The Effect of Financial Leverage on the Cost of Debt and Equity Capital
Cost of capital: r (%) r0 rB
Debt-to-equity ratio (D/E)

36. M&M Proposition I with tax
The Bigely Co. has $5,000 worth of debt outstanding that is selling at par. The coupon rate is 9% and the company tax rate is 34%.
What is the amount of the annual tax shield?
What is the present value of the tax shield?

37. M&M Proposition I with tax

38. M&M Proposition I with tax
Dawn, Inc. has 150,000 shares of stock outstanding at a market price of $30 a share. The cost of equity is 10%. The company is considering adding $1.5 million of debt with a coupon rate of 7%. The debt will sell at par. The tax rate is 35%.
What will the value of Dawn, Inc. be after they add the debt to their capital structure?
What is the levered value of the equity?

39. M&M Proposition I with tax

40. M&M Proposition I with tax
The Baker Co. has an unlevered cost of capital of 12% and a tax rate of 35%. The expected EBIT is $1,200. The company has $3,000 of debt which is selling at par. The coupon rate is 8%.
What is the value of the firm?

41. M&M Proposition I with tax

42. M&M Proposition II with tax
Charlie & Co. has $2,500 in bonds outstanding that are selling at par. The bonds have a 7% coupon rate and pay interest annually. The expected EBIT is $1,400 and the unlevered cost of capital is 10%. The tax rate is 35%.
What is the cost of equity?

43. M&M Proposition II with tax

44. M&M Proposition II with tax

45. M&M Proposition II with tax

46. M&M Proposition II with tax
Using the information from the last problem, you have debt of $2,500, equity of $7,475, VL of $9,975, RD of 7%, RE of 10.65% and a tax rate of 35%. What is the weighted average cost of capital (WACC)?

47. M&M Proposition II with tax

48. Summary: No Taxes
In a world of no taxes, the value of the firm is unaffected by capital structure.
This is M&M Proposition I:
VL = VU
Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.
In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders

49. Summary: Taxes
In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage.
This is M&M Proposition I:
VL = VU + TC D
Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.
In a world of taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.

50. Prospectus: Bankruptcy Costs
So far, we have seen M&M suggest that financial leverage does not matter, or imply that taxes cause the optimal financial structure to be 100% debt.
In the real world, most executives do not like a capital structure of 100% debt because that is a state known as “bankruptcy”.
In the next chapter we will introduce the notion of a limit on the use of debt: financial distress.
The important use of this chapter is to get comfortable with “M&M algebra”.

51. Capital Structure Structure of Bond Yield Rates r D E Bond Yield
The more debt the company uses, the higher its bond yield because of higher risk 51

52. WACC w/o taxes (traditional view)
Includes Bankruptcy Risk rE
WACC rD D V 52

53. Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. 53

54. Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress
=> Trade-off theory of capital structure 54

55. Financial Distress Market Value of The Firm Debt Maximum value of firm
Costs of
financial distress
Market Value of The Firm
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt 55