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Chapter 16Financial Leverage and Capital Structure Policy6/16/2024Chapter 168/9/20231Chapter OutlineThe Capital Structure QuestionThe Effect of Financial LeverageCapital Structure and the Cost of Equity CapitalM&M Propositions I and II with Corporate TaxesBankruptcy CostsOptimal Capital StructureThe Pie AgainThe Pecking-Order TheoryObserved Capital StructuresA Quick Look at the Bankruptcy Process16-26/16/2024Chapter OutlineThe Capital Str2Capital RestructuringWe are going to look at how changes in capital structure affect the value of the firm,all else equalCapital restructuring involves changing the amount of leverage a firm has without changing the firms assetsThe firm can increase leverage by issuing debt and repurchasing outstanding sharesThe firm can decrease leverage by issuing new shares and retiring outstanding debt16-36/16/2024Capital RestructuringWe are go3Choosing a Capital StructureWhat is the primary goal of financial managers?Maximize stockholder wealthWe want to choose the capital structure that will maximize stockholder wealthWe can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC16-46/16/2024Choosing a Capital StructureWh4The Effect of LeverageHow does leverage affect the EPS and ROE of a firm?When we increase the amount of debt financing,we increase the fixed interest expenseIf we have a really good year,then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year,we still have to pay our fixed costs and we have less left over for our stockholdersLeverage amplifies the variation in both EPS and ROE16-56/16/2024The Effect of LeverageHow does5Example:Financial Leverage,EPS and ROE Part IWe will ignore the effect of taxes at this stageWhat happens to EPS and ROE when we issue debt and buy back shares of stock?16-66/16/2024Example:Financial Leverage,E6Example:Financial Leverage,EPS and ROE Part IIVariability in ROECurrent:ROE ranges from 6%to 20%Proposed:ROE ranges from 2%to 30%Variability in EPSCurrent:EPS ranges from$0.60 to$2.00Proposed:EPS ranges from$0.20 to$3.00The variability in both ROE and EPS increases when financial leverage is increased16-76/16/2024Example:Financial Leverage,E7Break-Even EBITFind EBIT where EPS is the same under both the current and proposed capital structuresIf we expect EBIT to be greater than the break-even point,then leverage may be beneficial to our stockholdersIf we expect EBIT to be less than the break-even point,then leverage is detrimental to our stockholders16-86/16/2024Break-Even EBITFind EBIT where8Example:Break-Even EBIT16-96/16/2024Example:Break-Even EBIT16-98/9Example:Homemade Leverage and ROECurrent Capital StructureInvestor borrows$500 and uses$500 of her own to buy 100 shares of stockPayoffs:Recession:100(0.60)-.1(500)=$10Expected:100(1.30)-.1(500)=$80Expansion:100(2.00)-.1(500)=$150Mirrors the payoffs from purchasing 50 shares of the firm under the proposed capital structureProposed Capital StructureInvestor buys$250 worth of stock(25 shares)and$250 worth of bonds paying 10%.Payoffs:Recession:25(.20)+.1(250)=$30Expected:25(1.60)+.1(250)=$65Expansion:25(3.00)+.1(250)=$100Mirrors the payoffs from purchasing 50 shares under the current capital structure16-106/16/2024Example:Homemade Leverage an10Capital Structure TheoryModigliani and Miller(M&M)Theory of Capital StructureProposition I firm valueProposition II WACCThe value of the firm is determined by the cash flows to the firm and the risk of the assetsChanging firm valueChange the risk of the cash flowsChange the cash flows16-116/16/2024Capital Structure TheoryModigl11Capital Structure Theory Under Three Special CasesCase I AssumptionsNo corporate or personal taxesNo bankruptcy costsCase II AssumptionsCorporate taxes,but no personal taxesNo bankruptcy costsCase III AssumptionsCorporate taxes,but no personal taxesBankruptcy costs16-126/16/2024Capital Structure Theory Under12Case I Propositions I and IIProposition IThe value of the firm is NOT affected by changes in the capital structureThe cash flows of the firm do not change;therefore,value doesnt changeProposition IIThe WACC of the firm is NOT affected by capital structure16-136/16/2024Case I Propositions I and II13Case I-EquationsWACC=RA=(E/V)RE+(D/V)RDRE=RA+(RA RD)(D/E)RA is the“cost”of the firms business risk,i.e.,the risk of the firms assets(RA RD)(D/E)is the“cost”of the firms financial risk,i.e.,the additional return required by stockholders to compensate for the risk of leverage16-146/16/2024Case I-EquationsWACC=RA=14Figure 16.316-156/16/2024Figure 16.316-158/9/202315Case I-ExampleDataRequired return on assets=16%;cost of debt=10%;percent of debt=45%What is the cost of equity?RE=16+(16-10)(.45/.55)=20.91%Suppose instead that the cost of equity is 25%,what is the debt-to-equity ratio?25=16+(16-10)(D/E)D/E=(25-16)/(16-10)=1.5Based on this information,what is the percent of equity in the firm?E/V=1/2.5=40%16-166/16/2024Case I-ExampleData16-168/9/216The CAPM,the SML and Proposition IIHow does financial leverage affect systematic risk?CAPM:RA=Rf+A(RM Rf)Where A is the firms asset beta and measures the systematic risk of the firms assetsProposition IIReplace RA with the CAPM and assume that the debt is riskless(RD=Rf)RE=Rf+A(1+D/E)(RM Rf)16-176/16/2024The CAPM,the SML and Proposit17Business Risk and Financial RiskRE=Rf+A(1+D/E)(RM Rf)CAPM:RE=Rf+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)16-186/16/2024Business Risk and Financial R18Case II Cash FlowInterest is tax deductibleTherefore,when a firm adds debt,it reduces taxes,all else equalThe reduction in taxes increases the cash flow of the firmHow should an increase in cash flows affect the value of the firm?16-196/16/2024Case II Cash FlowInterest is19Case II-ExampleUnlevered FirmLevered FirmEBIT5,0005,000Interest0500Taxable Income5,0004,500Taxes(34%)1,7001,530Net Income3,3002,970CFFA3,3003,47016-206/16/2024Case II-ExampleUnlevered Fir20Interest Tax ShieldAnnual interest tax shieldTax rate times interest payment6,250 in 8%debt=500 in interest expenseAnnual tax shield=.34(500)=170Present value of annual interest tax shieldAssume perpetual debt for simplicityPV=170/.08=2,125PV=D(RD)(TC)/RD=DTC=6,250(.34)=2,12516-216/16/2024Interest Tax ShieldAnnual inte21Case II Proposition IThe value of the firm increases by the present value of the annual interest tax shieldValue of a levered firm=value of an unlevered firm+PV of interest tax shieldValue of equity=Value of the firm Value of debtAssuming perpetual cash flowsVU=EBIT(1-T)/RUVL=VU+DTC16-226/16/2024Case II Proposition IThe val22Example:Case II Proposition IDataEBIT=25 million;Tax rate=35%;Debt=$75 million;Cost of debt=9%;Unlevered cost of capital=12%VU=25(1-.35)/.12=$135.42 millionVL=135.42+75(.35)=$161.67 millionE=161.67 75=$86.67 million16-236/16/2024Example:Case II Proposition23Figure 16.416-246/16/2024Figure 16.416-248/9/202324Case II Proposition IIThe WACC decreases as D/E increases because of the government subsidy on interest paymentsRA=(E/V)RE+(D/V)(RD)(1-TC)RE=RU+(RU RD)(D/E)(1-TC)ExampleRE=12+(12-9)(75/86.67)(1-.35)=13.69%RA=(86.67/161.67)(13.69)+(75/161.67)(9)(1-.35)RA=10.05%16-256/16/2024Case II Proposition IIThe WA25Example:Case II Proposition IISuppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1.What will happen to the cost of equity under the new capital structure?RE=12+(12-9)(1)(1-.35)=13.95%What will happen to the weighted average cost of capital?RA=.5(13.95)+.5(9)(1-.35)=9.9%16-266/16/2024Example:Case II Propositio26Figure 16.516-276/16/2024Figure 16.516-278/9/202327Case IIINow we add bankruptcy costsAs the D/E ratio increases,the probability of bankruptcy increasesThis increased probability will increase the expected bankruptcy costsAt some point,the additional value of the interest tax shield will be offset by the increase in expected bankruptcy costAt this point,the value of the firm will start to decrease,and the WACC will start to increase as more debt is added16-286/16/2024Case IIINow we add bankruptcy 28Bankruptcy CostsDirect costsLegal and administrative costsUltimately cause bondholders to incur additional lossesDisincentive to debt financingFinancial distressSignificant problems in meeting debt obligationsFirms that experience financial distress do not necessarily file for bankruptcy16-296/16/2024Bankruptcy CostsDirect costs1629More Bankruptcy CostsIndirect bankruptcy costsLarger than direct costs,but more difficult to measure and estimateStockholders want to avoid a formal bankruptcy filingBondholders want to keep existing assets intact so they can at least receive that moneyAssets lose value as management spends time worrying about avoiding bankruptcy instead of running the businessThe firm may also lose sales,experience interrupted operations and lose valuable employees16-306/16/2024More Bankruptcy CostsIndirect 30Figure 16.616-316/16/2024Figure 16.616-318/9/202331Figure 16.716-326/16/2024Figure 16.716-328/9/202332ConclusionsCase I no taxes or bankruptcy costsNo optimal capital structureCase II corporate taxes but no bankruptcy costsOptimal capital structure is almost 100%debtEach additional dollar of debt increases the cash flow of the firmCase III corporate taxes and bankruptcy costsOptimal capital structure is part debt and part equityOccurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs16-336/16/2024ConclusionsCase I no taxes o33Figure 17.816-346/16/2024Figure 17.816-348/9/202334Managerial RecommendationsThe tax benefit is only important if the firm has a large tax liabilityRisk of financial distressThe greater the risk of financial distress,the less debt will be optimal for the firmThe cost of financial distress varies across firms and industries,and as a manager you need to understand the cost for your industry16-356/16/2024Managerial RecommendationsThe 35Figure 16.916-366/16/2024Figure 16.916-368/9/202336The Value of the FirmValue of the firm=marketed claims+nonmarketed claimsMarketed claims are the claims of stockholders and bondholdersNonmarketed claims are the claims of the government and other potential stakeholdersThe overall value of the firm is unaffected by changes in capital structureThe division of value between marketed claims and nonmarketed claims may be impacted by capital structure decisions16-376/16/2024The Value of the FirmValue of 37The Pecking-Order TheoryTheory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.Rule 1Use internal financing firstRule 2Issue debt next,new equity lastThe pecking-order theory is at odds with the tradeoff theory:There is no target D/E ratioProfitable firms use less debtCompanies like financial slack16-386/16/2024The Pecking-Order TheoryTheory38Observed Capital StructureCapital structure does differ by industryDifferences according to Cost of Capital 2019 Yearbook by Ibbotson Associates,Inc.Lowest levels of debtComputers with 5.61%debtDrugs with 7.25%debtHighest levels of debtCable television with 162.03%debtAirlines with 129.40%debt16-396/16/2024Observed Capital StructureCapi39Bankruptcy Process Part IBusiness failure business has terminated with a loss to creditorsLegal bankruptcy petition federal court for bankruptcyTechnical insolvency firm is unable to meet debt obligationsAccounting insolvency book value of equity is negative16-406/16/2024Bankruptcy Process Part IBus40Bankruptcy Process Part IILiquidationChapter 7 of the Federal Bankruptcy Reform Act of 1978Trustee takes over assets,sells them and distributes the proceeds according to the absolute priority ruleReorganizationChapter 11 of the Federal Bankruptcy Reform Act of 1978Restructure the corporation with a provision to repay creditors16-416/16/2024Bankruptcy Process Part IILi41Quick QuizExplain the effect of leverage on EPS and ROEWhat is the break-even EBIT,and how do we compute it?How do we determine the optimal capital structure?What is the optimal capital structure in the three cases that were discussed in this chapter?What is the difference between liquidation and reorganization?16-426/16/2024Quick QuizExplain the effect o42Comprehensive ProblemAssuming perpetual cash flows in Case II-Proposition I,what is the value of the equity for a firm with EBIT=$50 million,Tax rate=40%,Debt=$100 million,cost of debt=9%,and unlevered cost of capital=12%?16-436/16/2024Comprehensive ProblemAssuming 43Key Concepts and SkillsUnderstand the effect of financial leverage on cash flows and the cost of equityUnderstand the impact of taxes and bankruptcy on capital structure choiceUnderstand the basic components of the bankruptcy process16-446/16/2024Key Concepts and SkillsUnderst44谢谢！谢谢！45