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T16.1 Chapter Outline
Chapter 17Financial 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
T16.2 What’s Your Financing I.Q.?1. What do you need funding for?
a. To expand the businessb. To assist with business operationsc. To start the business
2. Describe your company’s profit history.a. A steady upward climbb. Even or flat, but steadyc. Inconsistent, or downward-sloping
3. How old is the business?a. Three or more yearsb. One to three yearsc. Less than one year
4. How well known are you within your market?a. Very well knownb. Somewhat knownc. 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
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.)
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.
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.
T16.17 The Optimal Capital Structure and the Value of the Firm
Big Apple, Inc. has no debt and a total market value of $80,000. EBIT is projected to be $4,000 if economic conditions are normal. EBIT is expected to be 30% higher if the economy is strong, or 60% lower if a recession occurs.
Big Apple is considering a $35,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase outstanding stock. There are now 2,000 shares outstanding. Ignore taxes for this problem.
a. Calculate EPS under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Big Apple goes through with the recapitalization. What do you observe?
Chelsea Corp. uses no debt. The weighted average cost of capital (WACC) is 12 percent. If the current market value of the equity is $25 million, and the corporate tax rate is 34 percent, what is the EBIT? What is the WACC? Explain.
According to M&M, V = VU + TCD.
In this case, V = $25M, WACC = 12%, and D = 0. So,
Fordebtful Industries has a debt/equity ratio of 2.5. Its WACC is 12 percent, and its cost of debt is 12 percent. The corporate tax rate is 35 percent.
a. What is Fordebtful’s cost of equity capital?
b. What is Fordebtful’s unlevered cost of equity capital?
c. What would the cost of equity be in part (a) if the debt/equity ratio were 1.5? What if it were 1.0? What if it were zero?