Leverage&Capital Structure

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved

13.1

IKJSAMUEL

Leverage and Capital Structure


13.2

Key Concepts and Skills

Understand the effect of financial leverage on cash flows and cost of equity

Understand the impact of taxes and bankruptcy on capital structure choice

Understand the basic components of the bankruptcy process


13.3

Chapter Outline

The Capital Structure QuestionThe Effect of Financial LeverageCapital Structure and the Cost of Equity CapitalCorporate Taxes and Capital StructureBankruptcy CostsOptimal Capital StructureObserved Capital StructuresA Quick Look at the Bankruptcy Process


13.4

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

Increase leverage by issuing debt and repurchasing outstanding shares

Decrease leverage by issuing new shares and retiring outstanding debt


13.5

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 firm value or minimizing WACC


13.6

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 expenseIf we have a really good year, then we pay our fixed

cost and we have more left over for our stockholdersIf 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


13.7

Example: Financial Leverage, EPS and ROEWe will ignore the effect of taxes at this stageWhat happens to EPS and ROE when we issue

debt and buy back shares of stock?

Financial Leverage Example


13.8

Example: Financial Leverage, EPS and ROEVariability in ROE

Current: ROE ranges from 6.25% to 18.75%Proposed: ROE ranges from 2.50% to 27.50%

Variability in EPSCurrent: EPS ranges from Rs1.25 to Rs3.75Proposed: EPS ranges from Rs0.50 to Rs5.50

The variability in both ROE and EPS increases when financial leverage is increased


13.9

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


13.10

Example: Break-Even EBIT

$2.00400,000

800,000EPS

$800,000EBIT

800,0002EBITEBIT

400,000EBIT200,000

400,000EBIT

200,000

400,000EBIT

400,000

EBIT

Break-even Graph


13.11

$2.00400,000

800,000EPS

$800,000EBIT

800,0002EBITEBIT

400,000EBIT200,000

400,000EBIT

200,000

400,000EBIT

400,000

EBIT


13.12

Example: Homemade Leverage and ROE Current Capital Structure

Investor borrows Rs2000 and uses Rs2000 of their own to buy 200 shares of stock

Payoffs: Recession: 200(1.25) - .1(2000) =

Rs50 Expected: 200(2.50) - .1(2000) =

Rs300 Expansion: 200(3.75) - .1(2000) =

Rs550

Mirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structure

Proposed Capital Structure Investor buys Rs1000 worth of

stock (50 shares) and Rs1000 worth of Trans Am bonds paying 10%.

Payoffs: Recession: 50(.50) + .1(1000) =

Rs125 Expected: 50(3.00) + .1(1000) =

Rs250 Expansion: 50(5.50) + .1(1000) =

Rs375

Mirrors the payoffs from purchasing 100 shares under the current capital structure


13.13

Capital Structure TheoryModigliani and Miller Theory of Capital

StructureProposition I – firm valueProposition II – WACC

The value of the firm is determined by the cash flows to the firm and the risk of the assets

Changing firm valueChange the risk of the cash flowsChange the cash flows


13.14

Capital Structure Theory Under Three Special CasesCase I – Assumptions

No corporate or personal taxesNo bankruptcy costs

Case II – AssumptionsCorporate taxes, but no personal taxesNo bankruptcy costs

Case III – AssumptionsCorporate taxes, but no personal taxesBankruptcy costs


13.15

Case I – Propositions I and II

Proposition IThe value of the firm is NOT affected by changes in

the capital structureThe cash flows of the firm do not change, therefore

value doesn’t change

Proposition IIThe WACC of the firm is NOT affected by capital

structure


13.16

Case I - Equations

WACC = RA = (E/V)RE + (D/V)RD

RE = RA + (RA – RD)(D/E)

RA is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets

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


13.17

Case I - ExampleData

Required return on assets = 16%, cost of debt = 10%; percent of debt = 45%

What is the cost of equity? RE = .16 + (.16 - .10)(.45/.55) = .2091 = 20.91%

Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio? .25 = .16 + (.16 - .10)(D/E) D/E = (.25 - .16) / (.16 - .10) = 1.5

Based on this information, what is the percent of equity in the firm? E/V = 1 / 2.5 = 40%


13.18

Figure 13.3Cost of capital(%)

Debt-equity ration(D/E)

RE

RD

WACC = RA

RE = RA + (RA – RD) X (D/E) by M&M Proposition IIRA = WACC = (E/V) X RE + (D/V) X RD

where V = D + E


13.19

The CAPM, the SML and Proposition IIHow does financial leverage affect systematic

risk?CAPM: RA = Rf + A(RM – Rf)

Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets

Proposition IIReplace RA with the CAPM and assume that the debt is

riskless (RD = Rf)

RE = Rf + A(1+D/E)(RM – Rf)


13.20

Business Risk and Financial Risk

RE = Rf + A(1+D/E)(RM – Rf)

CAPM: RE = Rf + E(RM – Rf)E = A(1 + D/E)

Therefore, the systematic risk of the stock depends on:Systematic risk of the assets, A, (Business risk)Level of leverage, D/E, (Financial risk)


13.21

Case II – Cash Flows

Interest is tax deductibleTherefore, when a firm adds debt, it reduces

taxes, all else equalThe reduction in taxes increases the cash flow

of the firmHow should an increase in cash flows affect

the value of the firm?


13.22

Case II - Example

Unlevered Firm Levered Firm

EBIT 5000 5000

Interest 0 500

Taxable Income 5000 4500

Taxes (34%) 1700 1530

Net Income 3300 2970

CFFA 3300 3470


13.23

Interest Tax ShieldAnnual interest tax shield

Tax rate times interest payment6250 in 8% debt = 500 in interest expenseAnnual tax shield = .34(500) = 170

Present value of annual interest tax shieldAssume perpetual debt for simplicityPV = 170 / .08 = 2125PV = D(RD)(TC) / RD = DTC = 6250(.34) = 2125


13.24

Case II – Proposition I

The value of the firm increases by the present value of the annual interest tax shieldValue of a levered firm = value of an unlevered firm

+ PV of interest tax shieldValue of equity = Value of the firm – Value of debt

Assuming perpetual cash flowsVU = EBIT(1-T) / RU

VL = VU + DTC


13.25

Example: Case II – Proposition I

DataEBIT = 25 million; Tax rate = 35%; Debt = $75

million; Cost of debt = 9%; Unlevered cost of capital = 12%

VU = 25(1-.35) / .12 = Rs.135.42 million

VL = 135.42 + 75(.35) = Rs161.67 millionE = 161.67 – 75 = Rs86.67 million


13.26

Figure 13.4Value ofthe firm(VL)

VL = VU + TC + X D = Value of firm with debt

VU = Value of firm with no debt

Total debt(D)

VU

= TC

= TC

TC X D = Present value of tax shield on debtVU

The value of the firm increases as total debt increases because ofthe interest tax shield. This is the basis of M&M Proposition I with taxes.


13.27

Case II – Proposition II

The WACC decreases as D/E increases because of the government subsidy on interest paymentsRA = (E/V)RE + (D/V)(RD)(1-TC)

RE = RU + (RU – RD)(D/E)(1-TC)

ExampleRE = .12 + (.12-.09)(75/86.67)(1-.35) = 13.69%

RA = (86.67/161.67)(.1369) + (75/161.67)(.09)(1-.35)RA = 10.05%


13.28

Case II – Proposition II Example

Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1.

What will happen to the cost of equity under the new capital structure?RE = .12 + (.12 - .09)(1)(1-.35) = 13.95%

What will happen to the weighted average cost of capital?RA = .5(.1395) + .5(.09)(1-.35) = 9.9%


13.29

Case II – Graph of Proposition IICost of Capital

D/E

RU

RE

RA

RD(1-TC)


13.30

Case III

Now we add bankruptcy costsAs the D/E ratio increases, the probability of

bankruptcy increasesThis increased probability will increase the expected

bankruptcy costsAt some point, the additional value of the interest tax

shield will be offset by the expected bankruptcy costAt this point, the value of the firm will start to

decrease and the WACC will start to increase as more debt is added


13.31

Bankruptcy Costs

Direct costsLegal and administrative costsUltimately cause bondholders to incur additional

lossesDisincentive to debt financing

Financial distressSignificant problems in meeting debt obligationsMost firms that experience financial distress do not

ultimately file for bankruptcy


13.32

More Bankruptcy Costs

Indirect bankruptcy costs Larger than direct costs, but more difficult to measure and

estimate Stockholders wish 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

Also have lost sales, interrupted operations and loss of valuable employees


13.33

Figure 13.5

Value ofthe firm(VL) VL = VU + TC X D

= Value of firm with debt

Financial distresscosts

VU = Value of firm with no debt

Actual firm value

Maximumfirm value VL*

D* Optimal amount of debt

Total debt(D)

Present value of taxshield on debt

According to the static theory, the gain from the tax shield on debt is offset by financial distress cost.An optimal capital structure exists that just balances the additional gain from leverage against theadded financial distress cost.


13.34

Conclusions

Case I – no taxes or bankruptcy costs No optimal capital structure

Case II – corporate taxes but no bankruptcy costs Optimal capital structure is 100% debt Each additional dollar of debt increases the cash flow of

the firmCase 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


13.35

Figure 13.6

Valueof thefirm(VL) PV of bankruptcy

costs

Net gain fromleverage

Case IIM&M (with taxes)

Case IIIStatic theoryCase IM&M (no taxes)

VL*

VU

Totaldebt (D)D*

Weightedaverage cost ofcapital(%)

Case IM&M (no taxes)

Case IIIStatic theory

Case IIM&M (with taxes)

WACC*

D*/E*Debt-equity ratio(D/E)

Case 1With no taxes or bankruptcy costs, the value of the firm and its weighted average costof capital are not affected by capitalstructures.

Case 2With corporate taxes and no bankruptcy costs,the value of the firm increases and the weightedaverage cost of capital decreases as the amountof debt goes up.

Case 3With corporate taxes and bankruptcy costs,the value of the firm, VL, reaches a maximum atD*, the optimal amount of borrowing. At the sametime, the weighted average cost of capital, WACC,is minimized at D*/E*.


13.36

Additional Managerial RecommendationsThe tax benefit is only important if the firm has

a large tax liabilityRisk of financial distress

The greater the risk of financial distress, the less debt will be optimal for the firm

The cost of financial distress varies across firms and industries and as a manager you need to understand the cost for your industry


13.37

Observed Capital Structure

Capital structure does differ by industriesDifferences according to Cost of Capital 2000

Yearbook by Ibbotson Associates, Inc.Lowest levels of debt

Drugs with 2.75% debt Computers with 6.91% debt

Highest levels of debt Steel with 55.84% debt Department stores with 50.53% debt


13.38

Bankruptcy Process – Part I

Business failure – business has terminated with a loss to creditors

Legal bankruptcy – petition federal court for bankruptcy

Technical insolvency – firm is unable to meet debt obligations

Accounting insolvency – book value of equity is negative


13.39

Bankruptcy Process – Part II

LiquidationChapter 7 of the Federal Bankruptcy Reform Act of

1978Trustee takes over assets, sells them and distributes

the proceeds according to the absolute priority ruleReorganization

Chapter 11 of the Federal Bankruptcy Reform Act of 1978

Restructure the corporation with a provision to repay creditors


13.40

Chapter 13 Quick Quiz

Explain the effect of leverage on EPS and ROEWhat is the break-even EBIT?How do we determine the optimal capital

structure?What is the optimal capital structure in the

three cases that were discussed in this chapter?What is the difference between liquidation and

reorganization?

Leverage&Capital Structure

Documents

effect of leverage

mcgrawhill companies

stockholders leverage

capital structures

eps eps ranges

capital structure2001

capital structurewhat

capital structure question