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Financial Leverage and
Capital Structure Policy
CHAPTER 16
Capital Restructuring
 What is meant by capital restructuring
 What is the primary goal of financial managers?
 Can leverage help in achieving such goals?
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
 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
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 the
value of the firm or minimizing the WACC
Financial Leverage
 The extent to which a firm relies on debt
 The more debt financing a firm uses in its capital structure,
the more financial leverage it employs
Financial leverage, EPS, and ROE: an example
current
proposed
Asset
8,000,000
8,000,000
debt
0
4,000,000
Equity
8,000,000
4,000,000
Debt-equity ratio
0
1
Share price
20
20
Shares out standing
400,000
200,000
Interest rate
10%
10%
Financial leverage, EPS, and ROE: an example
Current capital structure : No Debt
Recession
expected
expansion
EBIT
500,000
1,000,000
1,500,000
Interest
0
0
0
Net income
500,000
1,000,000
1,500,000
ROE
6.25%
12.5%
18.75%
EPS
1.25
2.5
3.75
Proposed capital structure : debt= 4$ million
EBIT
500,000
1,000,000
1,500,000
Interest
400,000
400,000
400,000
Net income
100,000
600,000
1,100,000
ROE
2.5%
15%
27.5%
EPS
0.5$
3
5.5
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
Ex 1 Page 540
 Maynard, Inc., has no debt outstanding and a total market value of
250,000$. EBIT are projected to be 28,000$ if economic conditions are
normal. If there is strong expansion in the economy, then EBIT will be 30
percent higher. If there is a recession, then EBIT will be 50 percent lower.
Maynard is considering a 90,000$ debt issue with a 7 percent interest rate.
The proceeds will be used to repurchase a share of stock. There are
currently 5,000 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 the economy goes with recapitalization.
What do you observe?
Ex 4 Page 542
 James Corporation is comparing two different capital structures:
an all equity plan (plan I) and a levered plan (plan II). Under
plan I, the company would have 160,000 shares of stock
outstanding. Under plan II, there would be 80,000 shares of
stock outstanding and 2.8$ million in debt outstanding. The
interest rate on the debt is 8 percent and there are no taxes.
A. If EBIT is 350,000$, which plan will result in the higher EPS?
B. If EBIT is 500,000$, which plan will result in the higher EPS?
C.
What is the break-even EBIT?
Corporate borrowing & home made leverage
1.
The effect of leverage depends on the company’s EBIT. When
EBIT is relatively high, leverage is beneficial
2.
Under the expected scenarios, leverage increase the returns to
shareholders, as measured by both ROE and EPS
3.
Shareholders are exposed to more risk under the proposed
capital structure because the EPS and ROE are much more
sensitive to changes in EBIT in this case
4.
Because of the impact that financial leverage has on both the
expected return to stockholder and the riskiness of the stock,
capital structure is an important consideration
Corporate borrowing & home made leverage
 Homemade leverage: the use of personal borrowing to
change the overall amount of financial leverage to which
the individual is exposed.
Corporate borrowing & home made leverage
Proposed capital structure
recession
expected
expansion
EPS
0.5$
3$
5.5$
Earnings for 100 shares
50
300
550
Original capital structure and homemade leverage
EPS
1.25
2.5
3.75
Earnings for 200 shares
250
500
750
Less: interest on $2,000 at 10%
200
200
200
Net earnings
50
300
550
Ex 9 Page 543
 ABC Co. and XYZ Co. are identical firms in all respects except for
their capital structure. ABC is all equity financed with 600,000$
in stock. XYZ uses both stock and perpetual debt; its stock is
worth 300,000$ and the interest rate on its debt is 8 percent.
Both firms expect EBIT to be 80,000$
A. Rico owns 30,000$ worth of XYZ’s stock. What rate of return is
he expecting?
B. Show how Rico could generate exactly the same cash flows and
rate of return by investing in ABC and using homemade
leverage?
Capital Structure Theory
 Modigliani and Miller (M&M)Theory of Capital
Structure

Proposition I: the value of the firm is independent of
the firm’s capital structure

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 (THE PIE MODEL)
Capital Structure Theory
 Proposition II

The firm’s cost of equity capital is a positive linear function of
the firm’s capital structure

RE = RA + (RA – RD)(D/E)

The cost of equity depends on three things

The WACC of the firm is NOT affected by capital structure
Capital Structure Theory
Example

Required return on assets = 16%; cost of debt = 10%;
debt=45%
 What is the cost of equity?
 Suppose instead that the cost of equity is 25%, what is the
debt-to-equity ratio?
 Based on this information, what is the percent of equity in
the firm?
M & M proposition I and II with corporate taxes
 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?
M & M proposition I and II with corporate taxes
Firm U
Firm L
EBIT
1,000
1,000
I
0
80
Taxable income
1,000
920
Taxes (30%)
300
276
NI
700
644
M & M proposition I and II with corporate taxes
CFFA
Firm U
Firm L
EBIT
1,ooo
1,ooo
Taxes
300
276
total
700
724
Cash flow
Firm U
Firm L
To stock holder
700
644
To bond holder
0
80
total
700
724
M & M proposition I with taxes
M & M proposition I and II with corporate taxes
 Interest tax shield: the tax saving attained by a firm
from interest expense
 Proposition I with taxes:
 Value of a levered firm = value of an unlevered firm + PV of
interest tax shield
 VL = VU + DTC
Example
 EBIT = 25 million; Tax rate = 35%; Debt = $75 million;
Cost of debt = 9%; Unlevered cost of capital = 12%
 Calculate the PV of VU, VL?
Proposition II with taxes
Ex 10 Page 543
 Wood Crop. Uses no debt. The WACC is 9 percent. If the
current market value of the equity is 23$ million and there
are no taxes, what is EBIT?
Ex 11 Page 543
 In the previous question suppose that corporate tax rate is
35 percent. What is EBIT? What is the WACC? Explain?
Ex 14 Page 543
 Frederick & Co. expects its EBIT to be 92,000$ every year
for ever. The firm can borrow at 9 percent. Frederick
currently has no debt, and its cost of equity is 15 percent. If
the tax rate is 35 percent, what is the value of the firm?
What will the value be if the company borrows 60,000$
and uses the proceeds to repurchase shares?
Ex 15 Page 544
 In problem 14, what is the cost of equity after
recapitalization? What is the WACC? What are the
implications for the firm’s capital structure decision?
Bankruptcy Costs
 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

Firms that experience financial distress do not necessarily file
for bankruptcy
Bankruptcy Costs
 Indirect bankruptcy costs

Larger than direct costs, but more difficult to measure and estimate

Stockholders want 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

The firm may also lose sales, experience interrupted operations and
lose valuable employees
Optimal Capital Structure
 The static theory of capital structure:
Optimal Capital Structure and the cost of capital
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 is just
offset by the increase in expected bankruptcy costs
Managerial recommendations
 Taxes
 Financial distress