Financial Management FIN300 Leverage and Capital Structure.

Financial Management

FIN300

Leverage and Capital Structure

Objectives

• Upon completion of this lesson, you will be able to:

– Discuss the effect of financial leverage– Analyze the impact of taxes and bankruptcy

on capital structure choice– Identify the essentials of the bankruptcy

process

Choosing aCapital Structure

• What is the primary goal of financial managers?– Maximize shareholder value

• We want to choose the capital structure that will maximize shareholder value

• We can maximize shareholder value by maximizing firm value or minimizing WACC

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 amount of interest expense– If we have a really good year, then we pay our

interest costs and we have more left over for our stockholders

– If we have a really bad year, we still have to pay our interest costs and we have less left over for our stockholders

– Leverage amplifies the variation in both EPS and ROE and increases the risk of equity, which is called financial risk

Issuing New Debtto Repurchase Stock

• Effect on value of firm before any tax effects– Pretax cost of debt is lower than cost of equity– Risk of stock will increase, thereby increasing cost of

equity– Asset structure remains the same, as does required

return on assets, which is equal to the WACC– Change in capital structure has no effect on value of

the firm or on WACC– EBIT remains the same

Tax Effect of Leverage

• Effect on value of profitable firm after tax effects– Where EBIT remains the same– Interest on debt reduces taxable income, or

EBT, thereby reducing taxes– CFFA increases

Example: LeverageEffect on CFFA

Unlevered Firm

Levered Firm

EBIT 5,000 5,000

Interest 0 500

Taxable Income 5,000 4,500

Taxes (34%) 1,700 1,530

Net Income 3,300 2,970

CFFA 3,300 3,470

Example: LeverageEffect on ROE and EPS

Unlevered Firm Levered Firm

Debt 0 5,000

Equity 15,000 10,000Shares 3,000 2,000

Net Income 3,300 2,970

ROE 3.3/15 = 22% 2.97/10 = 29.7%

EPS 3.3/3 = $1.10 2.97/2 = $1.49

Measuring Risk Effectof Leverage

• WACC = RA = (E/V)RE + (D/V)RD

• RE = RA + (RA – RD)(D/E)

– RA is the cost of the firm’s systematic or business risk, the risk of the firm’s assets

– (RA – RD)(D/E) is the cost of the firm’s financial risk, the additional return required by stockholders to compensate for the risk of leverage

Optimal Capital Structure

• Leverage can increase– Return on equity– Earnings per share– Stockholder value

• Increased leverage can result in– Higher required return on equity– Higher required interest rate on debt

• Conclusion– There are limits to the value of leverage

Bankruptcy Costs

• If our firm defaults on payment of interest or principle, the bondholders can force us into bankruptcy

• As the D/E ratio increases, the probability of bankruptcy increases

• This increased probability will increase the expected costs of bankruptcy or of avoiding bankruptcy

• At some point, the additional value of the interest tax shield will be offset by the financial distress costs

• At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added

Bankruptcy Costs, continued

• Direct costs– Legal and administrative costs– Ultimately cause bondholders to incur

additional losses– Disincentive to debt financing

• Financial distress– Significant problems in meeting debt

obligations– May have to sell productive assets– Most firms that experience financial distress

do not ultimately file for bankruptcy

Bankruptcy Process

• Liquidation– Chapter 7 of the Federal Bankruptcy Reform Act of

1978– Trustee takes over assets, sells them, and

distributes the proceeds according to the absolute priority rule

• Reorganization– Chapter 11 of the act– Restructure the corporation with a provision to

protect creditors– May including rescinding contractual obligations

such as leases or union contracts

Check Your Understanding

Summary

• Effect of financial leverage

• Taxes and bankruptcy

• Bankruptcy process