Download Financial Leverage and Capital Structure Policy

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
Review the example in word file CH16 
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 569 (SOLUTION IN WORD CH16)
 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.
 REVIEW THE WORD CH16 EXAMPLE ON HOMEMADE
LEVERAGE.
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 (no taxes): 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. Which means the value of a levered firm (VL) is equal to
the unlevered firm VU

(VL=VU)
The cash flows of the firm do not change; therefore, value doesn’t
change (THE PIE MODEL)

A firm’s WACC is the same no matter what mixture of debt and
equity is used to finance the firm.
Capital Structure Theory
We want to see what happens when we the debt equity ratio
in a firm is changed (ignoring taxes).
• Since WACC = required rate of return on firms assets
 WACC =RA . And when we put RE in one side we will have:
RE = RA + (RA – RD)(D/E)
 We know as a fact that the cost of debt is lower than the
cost of equity. However, this change is offset by the
increase in the cost of equity from borrowing.
 Proposition II (no tax)

RE = RA + (RA – RD)(D/E)

The firm’s cost of equity capital is a positive linear function of the firm’s
capital structure

The cost of equity depends on three things: WACC or RA, cost of debt,
and D/E debt equity ratio.
Implications II 
The cost of equity rises as the firm increases its use of debt financing. 
The risk of equity depends on two things: 
A. the riskiness of the firm’s operations(Business risk)and this risk
determines RA.
B. financial risk and it is determined by D/E.
Capital Structure Theory
Example

Required return on assets = 16%(same as WACC=16%)
cost of debt = 10%; debt=45% (tax is ignored)

What is the cost of equity?
RE = RA + (RA – RD)(D/E)
= 0.16 + (0.16-0.10)(45/55)
Re = 20.9%

Suppose instead that the cost of equity is 22%, what is the debt-to-equity ratio?
RE = RA + (RA – RD)(D/E)
0.22= 0.16 + 0.06 (D/E)
0.22 -0.16 = 0.06 (D/E)
0.06 = 0.06 (D/E)
D/E = 1

Based on this information, what is the percent of equity in the firm?
50%
M & M proposition I and II with corporate taxes
Example page 547
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
We see from the result that capital structure has some effect because
the cash flow from U and L is not the same, even thought the two firms
have identical assets.
Cash flow
Firm U
Firm L
To stock holder
700
644
To bond holder
0
80
total
700
724
The fact that interest is deductible for tax purposes has generated a tax
saving = interest payment ($80) * tax rate (0.30) = $24 = interest tax
shield
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 with taxes
M & M proposition I and II
with corporate taxes

Debt has two features that we haven’t talked about in M&M Proposition I& II (with tax
ignored):
1. interest paid on debt is tax deductible.(good for a firm)
2. failure to meet debt obligations can result in bankruptcy. (not good for a firm).

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

Implications of proposition I:
(page 548)
1. Debt financing is highly advantageous.
2. A firm WACC decreases as the firm realize more heavily on debt financing
Example
 EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of
debt = 9%; Unlevered cost of capital = 12%
 Calculate the PV of VU, VL?
VU = EBIT * (1- Tc)/ RU
= 25,000,000*(1-0.35)/ 0.12 = 135,416,666.7
The value of levered firm =
VL= VU+ Tc*D
= 135,416,666.7 + (0.35*75,000,000)= 161,666,666.7
M&M proposition II with tax
Proposition II with tax: 
RE = RU+ (RU-RD) (D/E) (1-Tc)
RU= unlevered cost of capital or cost of capital of firm with
no debt.
Implications of proposition II (with tax):
cost of equity rises as the firm increases its use of debt financing. 
The risk of equity depends on two things: 
A. the riskiness of the firm’s operations(Business risk)and this risk
determines RA.
B. financial risk and it is determined by D/E.
Proposition II with taxes
Ex 10 Page 571
 Wood Crop. Uses no debt. The WACC is 9 percent. If the
current market value of the equity is 23$ million and there
are no taxes, what is EBIT?
With no taxes, the cost of capital of unlevered firm is the
cost of equity which can be used as a discount rate for
the firm’s value.
VU = EBIT/WACC
$23,000,000 = EBIT/0.09
EBIT= 0.09 ($23,000,000)
EBIT= $2,070,000
Ex 11 Page 543
 In the previous question suppose that corporate tax rate is
35 percent. What is EBIT? What is the WACC? Explain?
If there are corporate taxes, the value
of unlevered firm is:
VU= EBIT (1-tc)/ RU
EBIT:
$23,000,000 = EBIT (1-.35)/0.09
EBIT= $3,184,615.38
WACC = still the same 9%
Ex 14 Page 543

Frederick & Co. expects its EBIT to be 92,000$ 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?
The value of the unlevered firm is:
VU = EBIT(1 – tC)/RU
VU = $92,000(1 – .35)/.15
VU = $398,666.67
The value of the levered firm is:
.b
VL = VU + tCD
VL = $398,666.67 + .35($60,000)
VL = $419,666.67
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?
We can find the cost of equity using M&M Proposition II with taxes.
Doing so, we find:
RE = RU + (RU – RD)(D/E)(1 – t)
RE = .15 + (.15 – .09)($60,000/$398,667)(1 – .35)
RE = .1565 or 15.65%
Using this cost of equity, the WACC for the firm after recapitalization is:
WACC = (E/V)RE + (D/V)RD(1 – tC)
WACC = .1565($398,667/$419,667) + .09(1 – .35)($60,000/$419,667)
WACC = .1425 or 14.25%
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

Indirect cost are 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
Static theory of capital structure 
This theory says that firms borrow up to the point where the tax benefit from an
extra dollar in debt is exactly equal to the cost that comes from the increased
probability of financial distress.
Illustration to the next figure of the value of the firm
First line (yellow), represent M&M proposition I with No tax (straight line)
Next line (blue), represent M&M proposition I with tax. (Upward slopping straight
line)
Third line (red), represent the static theory of capital structure or the optimal
capital structure(the value of the firm rises to a maximum and then decline
beyond that point.
At the maximum value of the firm VL* is reached at D* which means the optimal
amount of borrowing.
The difference between the value of the firm in static theory and M&M value of
the firm with tax is the loss in value from the possibility of financial distress
Optimal Capital Structure
 The static theory of capital structure:
Optimal Capital Structure
We know that the capital structure that maximizes the 
value of the firm is the one that minimize the cost of
capital.
Next figure represent the WACC line which 
correspond to the static theory.
Decline at first because the after tax cost of debt is cheaper than o
cost of equity.
However, at some point the cost of debt begins to rise, and the o
fact that debt is cheaper than equity is offset by the financial
distress cost.
Minimum WACC occurs at D/E*. o
Optimal Capital Structure and the cost of capital
Conclusions
 Case I – no taxes or bankruptcy costs

No optimal capital structure

The value of the firm and its WACC are not affected by 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

WACC decreases as much as the amount of debt goes up.
 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
o The tax benefit from leverage is important only to firm that are
in a tax paying position.
o Firm with accumulated losses will get little value from the
interest tax shield.
o The higher the tax rate, the greater the incentive to borrow.
 Financial distress
o the greater the volatility in EBIT, the less a firm should borrow.
In other words, firms with greater risk of experiencing financial
distress, will borrow less than other firms.