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Corporate Financial Management
Professor James J. Barkocy
“You can observe a lot by
watching.”
Yogi Berra
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering going
into debt. (Maybe some of the original shareholders
want to cash out.)
Current
Assets
$8,000
Debt
$0
Equity
$8,000
Debt/Equity ratio
0
Interest rate
n/a
Shares outstanding
400
Share price
$20
Proposed
$8,000
$4,000
$4,000
1/1
10%
200
$20
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EPS and ROE Under Both Capital Structures
All-Equity
Recession
EBIT
$400
Interest
0
Net income
$400
EPS
1.00
ROA (Earnings/Assets)
5%
ROE (Earnings/Equity)
5%
Current Shares Outstanding = 400 shares
Expected
$1,200
0
$1,200
$3.00
15%
15%
Expansion
$2,000
0
$2,000
$5.00
25%
25%
Levered
Recession
EBIT
$400
Interest
-400
Net income
$0
EPS
$0
ROA
5%
ROE
0%
Proposed Shares Outstanding = 200 shares
Expected
$1,200
-400
$800
$4.00
15%
20%
Expansion
$2,000
-400
$1,600
$8.00
25%
40%
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Value and Capital Structure
Assets
Liabilities and
Value of cash flows from
firm’s real assets and
operations
Stockholder’s Equity
Market value of debt
Market value of equity
Value of Firm
Value of Firm
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M&M (Debt Policy Doesn’t Matter)
 Modigliani & Miller
 When there are no taxes and capital markets
function well, it makes no difference whether
the firm borrows or individual shareholders
borrow. Therefore, the market value of a
company does not depend on its capital
structure.
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Homemade Leverage: An Example
Strategy A: Buy 100 of Levered Recession Expected Expansion
EPS of Levered Equity
$0.0
$4.00
$8.00
Earnings per 100 shs.
0
400
800
Initial Cost = 100 shs. @ $20/sh. = $2,000
Strategy B: Homemade Leverage
EPS of Unlevered Equity
Earnings per 200 shs.
Interest @10 on $2,000
Net Earnings
Recession Expected Expansion
$1.00
$3.00
$5.00
200
-200
0
600
-200
400
1,000
-200
800
Initial Cost = 200 shs. @ $20/sh. = $4,000 - $2,000 borrowed
= $2,000
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M& M’s Proof
Type of Firm
Action Taken
Next period
Note:
Firm A
All Equity
V=E
Firm B
Some equity & some debt
V= D+E
Investor buys
“a” of equity
aV
Investor buys fraction “a”
of both debt and equity
aD + aE = a(D+E)=aV
Investor receives
a fraction of CF
aX
Investor receives the
following
a(X-rD)+ arD = aX
X-rD is the cash flow less interest expense
arD is the “piece” of interest that goes to the investor
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The Cost of Capital
WACC=
B
S
 rB +
 rS
B +S
B +S
Unlevered Firm: (0 x 10%) + (1.00 x 15%) = 15%
Levered Firm:
(.50 x 10%) + (.50 x 20%) = 15%
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Weighted Average Cost of Capital
without taxes (M&M view)
r
rs
WACC
rb
Includes Bankruptcy Risk
B
V
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Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-equity firm
S
Levered firm
G
G
S
B
The levered firm pays less in taxes than does the all-equity
firm.
Thus, the sum of the debt plus the equity of the levered
firm is greater than the equity of the unlevered firm.
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C.S. & Corporate Taxes
Example - You own all the equity of Space Babies Diaper
Co. The company has no debt. The company’s annual
cash flow is $10,000, before interest and taxes. The
corporate tax rate is 35%. You have the option to
exchange part of your equity position for 6% bonds
with a face value of $50,000.
Should you do this and why?
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C.S. & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. The company has
no debt. The company’s annual cash flow is $10,000, before interest and taxes.
The corporate tax rate is 35%. You have the option to exchange part of your
equity position for 6% bonds with a face value of $50,000.
Should you do this and why?
EBIT
Interest Pmt
Pretax Income
Taxes @ 35%
Net Cash Flow
All Equity 1/2 Debt
10,000 10,000
0
3,000
10,000
7,000
3,500
2,450
6,500
4,550
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C.S. & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. The company has no
debt. The company’s annual cash flow is $10,000, before interest and taxes. The
corporate tax rate is 35%. You have the option to exchange part of your equity
position for 6% bonds with a face value of $50,000.
Should you do this and why?
EBIT
Interest Pmt
Pretax Income
Taxes @ 35%
Net Cash Flow
All Equity 1/2 Debt
10,000 10,000
0
3,000
10,000
7,000
3,500
2,450
6,500
4,550
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C.S. & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. The company has no
debt. The company’s annual cash flow is $10,000, before interest and taxes. The
corporate tax rate is 35%. You have the option to exchange part of your equity
position for 6% bonds with a face value of $50,000.
Should you do this and why?
EBIT
Interest Pmt
Pretax Income
Taxes @ 35%
Net Cash Flow
All Equity 1/2 Debt
10,000 10,000
0
3,000
10,000
7,000
3,500
2,450
6,500
4,550
Total Cash Flow
All Equity = 6,500
*1/2 Debt = 7,550
(4,550 + 3,000)
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Capital Structure
Firm Value = Value of All Equity Firm + PV Tax Shield
VL = VU + TcB
Example
All Equity Value = 100,000
PV Tax Shield = D x Tc = 50000 x .35 =$17,500
Firm Value with 1/2 Debt = $117,500
15
Tax Shield and Value
16
The Effect of Financial Leverage on the Cost of Debt
and Equity Capital with Corporate Taxes
Cost of capital: r
(%)
rS  r0 +
rS  r0 +
B
 (r0  rB )
SL
B
 (1  TC )  (r0  rB )
SL
MM’s WACC
r0
rWACC 
B
SL
 rB  (1  TC ) +
 rS
B+SL
B + SL
rB
Debt-to-equity
ratio (B/S)
17
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.
Market Value =
Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
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Trade- Off Theory
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)
Present value of tax
shield on debt
VL = VU + TCB
Present value of
financial distress costs
Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt
Debt (B)
0
B*
Optimal amount of debt
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Bankruptcy Issues
20
Financial Choices
Trade-off
Theory
Pecking
Order
Theory
• Theory that capital structure is
based on a trade-off between tax
savings and distress costs of
debt.
• Theory stating that firms prefer
to issue debt rather than equity if
internal finance is insufficient.
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How Firms Establish Capital Structure
 Most Corporations Have Low Debt-Asset
Ratios.
 A number of firms use no debt.
 There are Differences in Capital Structure
Across Industries.
 There is evidence that firms behave as if they
had a target Debt to Equity ratio.
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Factors in Target D/E Ratio
 Taxes

If corporate tax rates are higher than bondholder tax
rates, there is an advantage to debt.
 Types of Assets

The costs of financial distress depend on the types of
assets the firm has.
 Uncertainty of Operating Income

Even without debt, firms with uncertain operating
income have high probability of experiencing
financial distress.
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