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Week 10

Lecture 10

Ross, Westerfield and Jordan 7e

Chapter 17

Financial Leverage and

Capital Structure Policy

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Last Lecture..

• Cost of Equity• Cost of Preferred Stock• Cost of Debt• Proportion or weight of each form of

financing• Cost of Capital = WACC

• Unadjusted/Adjusted• When should we use WACC?• Other approaches: pure play and subjective

• Flotation Costs

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Chapter 17 Outline

• The Capital Structure Question

• The Effect of Financial Leverage

• Capital Structure and the Cost of Equity Capital

• M&M Propositions I and II with Corporate Taxes

• Bankruptcy Costs

• Optimal Capital Structure

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Choosing a Capital Structure

• What is the primary goal of financial managers?• Maximize stockholder wealth

• Choose the optimal capital structure

• Maximize the value of the firm

• Minimize the WACC

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Capital Restructuring

• Financial leverage = the extent to which a firm relies on debt financing

• Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets

• The firm can increase leverage by issuing debt and repurchasing outstanding shares

• The firm can decrease leverage by issuing new shares and retiring outstanding debt

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The Effect of Leverage

• How does leverage affect the EPS and ROE of a firm?

• More debt financing, means more fixed interest expense

• In expansion, we have more income after we pay interest, have more left over for stockholders

• In recession, we still have to pay our costs therefore we have less left over for stockholders

• Leverage amplifies the variation in both EPS and ROE

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Example: Financial Leverage, EPS and ROE

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Break-Even EBIT

• Break-Even EBIT where:

EPS debt = EPS no debt

• If expected EBIT > break-even EBIT, then

leverage is beneficial to our stockholders

• If expected EBIT < break-even EBIT, then

leverage is detrimental to our stockholders

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Example: Break-Even EBIT

$500250

$125000 EBIT

125000250EBIT

125000500EBIT250EBIT

250EBIT500250EBIT250

250EBIT

500

EBIT

EPSEPS

shares

interestearnings

shares

earningsdebtdebt no

Break-even GraphEPS with No Debt = $500/500 = $1

EPS with Debt = ($500-$250)/250 = $1

Numbers in thousands

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Break Even EBIT

With debt

With no debt

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Capital Structure Theory

• Modigliani and Miller Theory of Capital Structure• Proposition I – firm value• Proposition II – cost of equity & WACC

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

• Changing firm value• Change the risk of the cash flows• Change the cash flows

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Capital Structure Theory Under Three Special Cases

• Case I – Assumptions• No taxes• No bankruptcy costs

• Case II – Assumptions• With taxes• No bankruptcy costs

• Case III – Assumptions• With taxes• With bankruptcy costs

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Case I – No Taxes

• Proposition I• The value of the firm is NOT affected by

changes in the capital structure• The cash flows of the firm do not change;

therefore, value doesn’t change

• Proposition II• Cost of Equity increases as Debt increases• The WACC of the firm is NOT affected by

capital structure

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Case I - No Taxes - 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

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Figure 17.3

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Case I - No Taxes - Example

• Data• Required return on assets = WACC = RA = 16%,• Cost of debt = RD = 10%• Percent of debt = D = 45%• E = 1 - 0.45 = 0.55 or 55%• D/E = 0.45/0.55 = 0.82

• What is the cost of equity?• RE = RA + (RA – RD)(D/E)

• RE = 0.16 + (0.16 – 0.10)(.45/.55) = 20.91%

• Proof for WACC:• WACC = RA = (E/V)RE + (D/V)RD

• WACC = RA = 0.55 * 20.91% + 0.45 * 10% = 16%

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Case I – No Taxes Example continued..

• What happens if the firm increases leverage so that D/E = 1.5? (before D/E = 0.82 when D=45%,E=55%)

• What is the cost of equity? • RE = RA + (RA – RD)(D/E)

• RE = 0.16 + (0.16 – 0.10)(1.5) = 0.25 or 25%

• Proof for WACC:• WACC = RA = (E/V)RE + (D/V)RD

• From D/E = 1.5, D = 60%, E = 40%

• WACC = 0.4 * 25% + 0.6 * 10% = 16%

D/E1

1

V

E

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The CAPM, Business Risk, Financial Risk and Proposition II

• How does financial leverage affect systematic risk?

• CAPM: RE = Rf + E(RM – Rf) – for equity

• CAPM: RA = Rf + A(RM – Rf) – for assets

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

assets, also called unleverred beta – the risk of the assets if the firm would have no debt ( in essence E = A if no debt)

• RE = RA + (RA – RD)(D/E)

• RE = RA + (RA – Rf)(D/E) - assume RD = Rf

• Proposition II• As we introduce debt in the firm:

• RE = Rf + A(1+D/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)

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Case II – Introducing Taxes

• What happens to the firm’s cash flows?• Interest is tax deductible• Therefore, when a firm adds debt, it reduces

taxes, all else equal• The reduction in taxes increases the cash flow

of the firm

• How should an increase in cash flows affect the value of the firm?

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Case II - with Taxes - Example

Unlevered FirmNo Debt

Levered FirmWith Debt

EBIT 5000 5000

Interest 0 (6250@8%) 500

Taxable Income

5000 4500

Taxes (34%) 1700 1530

Net Income 3300 2970

CFFA 3300 3470

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Interest Tax Shield

• Annual interest tax shield• Tax rate times interest payment• 6250 in 8% debt = 500 in interest expense• Annual tax shield = 0.34(500) = 170

• Present value of annual interest tax shield• Assume perpetual debt for simplicity• PV = 170 / 0.08 = 2125

CD

CD TDR

TRDPV

21250.3462500.08

0.340.086250PV

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Case II - with Taxes - Proposition I

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

firm + PV of interest tax shield• Assuming perpetual cash flows

• VU = EBIT(1-T) / RU

with no debt RU = RA= RE and VU = E

• VL = VU + D*TC

• E = VL - D

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Case II – with TaxesProposition I - Example

• Data Inc. has earnings of 25 million per year every year. The firm has no debt and the cost of capital is 12%. If tax is 35% what is the value of the firm?• EBIT = 25 million; Tax rate = TC= 35%;

Unlevered cost of capital = RU= 12% = RA = RE

VU = ?

• VU = EBIT(1-T) / RU

• VU = 25(1-0.35) / 0.12 = $135.42 million

• VU = E

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Case II – with TaxesProposition I - Example (cont.)

• Data Inc. decides to issue bonds that have a market value of 75 million at a cost of 9%. What is the value of the firm? What will be the value of equity?• D = $75 million, RD= 9%, VL = ?, E = ?

VU = 135.42 (calculated on previous slide)

• VL = VU + tax shield

• VL = VU + D*TC

• VL = 135.42 + 75(0.35) = $161.67 million

• E = VL - D• E = 161.67 – 75 = $86.67 million

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Figure 17.4 Case II - with Taxes Proposition I

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Case II – with Taxes - Proposition II

• Recap: In case I – Proposition II - no taxes:• RE increases as Debt increases

• WACC is unchanged

• When taxes are introduced in Case II:• RE increases as Debt increases

RE = RU + (RU – RD)(D/E)(1-TC)

• WACC decreases as D/E increases because the cost of debt decreases

RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)

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Case II – with Taxes Proposition II - Example

• Data Inc. info from Case II proposition I:• EBIT = 25 million; TC= 35%; D = $75 million;

RD= 9%; Unlevered cost of capital = RU= 12%

E = $86.67m; VL = $161.67mD/E = 75/86.67 = 0.87, E/V = 86.67/161.67 = 0.54,D/V = 75/161.67 = 0.46

• RE = RU + (RU – RD)(D/E)(1-TC)• RE = 0.12 + (0.12-0.09)(0.87)(1-0.35) = 13.69%

• RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)• RL = WACC = (0.54)(0.1369) + (0.46)(0.09)(1-.35) =

10.05%

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Example: Case II – Proposition II

• Suppose Data Inc. changes its capital structure so that the debt-to-equity ratio becomes 1.• Before: D/E = 0.87, E= 54%, D=46%• Now: D/E = 1, E= 50%, D=50%

• What will happen to the cost of equity under the new capital structure? (previously 13.69%)

• RE = 0.12 + (0.12 – 0.09)(1)(1-0.35) = 13.95%

• What will happen to the weighted average cost of capital? (previously 10.05%)

• WACC = 0.5(0.1395) + 0.5(0.09)(1-0.35) = 9.9%

• What if D/E = 1.25?, RE = ?, WACC = ?

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Figure 17.5 - Case II with Taxes Proposition II

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Case III – with Bankruptcy Costs

• Now we add bankruptcy costs• As the D/E ratio increases, the probability of

bankruptcy increases• This increased probability will increase the

expected bankruptcy costs• At some point, the additional value of the interest

tax shield will be offset by the increase in expected bankruptcy cost

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

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Figure 17.6 – Case III with Bankruptcy costs

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Figure 17.7 Case III with Bankruptcy costs

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Bankruptcy Costs

• Direct costs• Legal and administrative costs

• Indirect costs• Larger than direct costs & more difficult to

measure and estimate

• Financial distress costs• All costs associated with going bankrupt

and/or avoiding bankruptcy

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Conclusions

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

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

of the firm

• Case 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 just offsets the increase in expected bankruptcy costs

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Figure 17.8

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Managerial Recommendations

• The tax benefit is only important if the firm has a large tax liability

• Risk 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

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End Chapter 17