FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY Chapter 16.
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Transcript of FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY Chapter 16.
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY
Chapter 16
16-2
Quiz on WACCCompany’s D/E ratio is 2/3, they
need 5500 financing and they want to keep the same D/E ratio. How much equity they should issue? (1p.)
Company’s cost of equity is 14% and cost of debt is 8%, tax is 40%; D/E ratio is ¼. What is WACC? (2p).
16-3
Chapter OutlineThe Capital Structure DecisionThe Effect of Financial LeverageCapital Structure and the Cost of
Equity Miller&Modigliani PropositionsBankruptcy CostsOptimal Capital StructureExtended Pie ModelObserved Capital Structures
16-4
Capital RestructuringCapital restructuring involves
changing the amount of leverage a firm has without changing the firm’s assets
Increase leverage by issuing debt and repurchasing outstanding shares
Decrease leverage by issuing new shares and retiring outstanding debt
Financial leverage = the extent to which the firm relies on debt
16-5
Choosing a Capital StructureWhat is the primary goal of
financial managers?◦Maximize stockholder wealth
Stockholders’ wealth can be maximized by maximizing firm value or minimizing WACC
16-6
The 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 expense
◦ If 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 stockholders
Leverage amplifies the variation in both EPS and ROE
16-7
Financial Leverage, EPS and ROE, example (1)
Current capital structure: No debt Recession Expected Expansion
EBIT $500,000 $1,000,000$1,500,00
0Interest 0 0 0Net income 500,000 1,000,000 1,500,000ROE 6.25% 12.50% 18.75%EPS $1.25 $2.50 $3.75
Proposed capital structure: Debt = $ 4 mln Recession Expected Expansion
EBIT $500,000 $1,000,000$1,500,00
0Interest 400,000 400,000 400,000Net income 100,000 600,000 1,100,000ROE 2.50% 15.00% 27.50%EPS $0.50 $3.00 $5.50
16-8
Financial Leverage, EPS and ROE, example (2)
Variability in ROE◦Current: ROE ranges from 6.25% to
18.75%◦Proposed: ROE ranges from 2.50% to
27.50%Variability in EPS
◦Current: EPS ranges from $1.25 to $3.75
◦Proposed: EPS ranges from $0.50 to $5.50
The variability in both ROE and EPS increases when financial leverage is increased
16-9
Degree of financial leverage
EBITinchangePercentage
EPSinchangePercentageleveragefinancialofDegree
InterestEBIT
EBITleveragefinancialofDegree
16-10
Break-Even EBITFind EBIT where EPS is the same
under both the current and proposed capital structures
If EBIT is expected to be greater than the break-even point, then leverage is beneficial to stockholders
If EBIT is expected to be less than the break-even point, then leverage is detrimental to stockholders
16-11
Financial Leverage, EPS and ROEBreakeven (indifference) EBIT solution:
$2.00400,000
800,000EPS
$800,000EBIT
800,0002EBITEBIT
400,000EBIT200,000
400,000EBIT
200,000
400,000EBIT
400,000
EBIT
16-12
Homemade Leverage and ROE
Current Capital Structure◦ Investor borrows $2000
and uses $2000 of their own to buy 200 shares of stock
◦ Payoffs: Recession: 200(1.25)
- .1(2000) = $50 Expected: 200(2.50)
- .1(2000) = $300 Expansion: 200(3.75)
- .1(2000) = $550◦ Mirrors the payoffs from
purchasing 100 shares from the firm under the proposed capital structure
Proposed Capital Structure◦ Investor buys $2000
worth of stock (100 shares)
◦ Payoffs: Recession:
100(0.50) = $50 Expected:
100(3.00) = $300 Expansion:
100(5.50)= $550
16-13
Homemade leverageThe use of personal borrowing to
change the overall amount of financial leverage to which individual is exposed
The investor can both “lever” his position through borrowing or “unlever” - through lending
16-14
Capital Structure TheoryModigliani and Miller Theory of
Capital Structure◦Proposition I – the pie model◦Proposition II – WACC
The value of the firm is determined by the cash flows to the firm and the risk of the assets
16-15
Capital Structure Theory Under Three Special Cases
Case I – Assumptions (M&M)◦No corporate or personal taxes◦No bankruptcy costs
Case II – Assumptions (M&M)◦Corporate taxes◦No bankruptcy costs
Case III – Assumptions (Static Theory)◦Corporate taxes◦Bankruptcy costs
16-16
Case I – No Taxes or Bankruptcy Costs
M&M 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◦The WACC of the firm is NOT affected
by capital structure
16-17
Case IWACC = RA = (E/V)RE + (D/V)RD
RE = RA + (RA – RD)(D/E)
◦RA is the required return on the firm’s assets
◦(RA – RD)(D/E) is the additional return required by stockholders to compensate for the risk of leverage
16-18
Case I, exampleData
◦Required return on assets = 16%, cost of debt = 10%; percent of 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?
16-19
The CAPM, the SML and Proposition II
CAPM: RA = Rf + A(RM – Rf)◦Where A is the firm’s asset beta and
measures the systematic risk of the firm’s assets
Proposition II◦RE = Rf + A(RM – Rf)(1+D/E)
16-20
Business Risk and Financial Risk
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)
RE = Rf + A(1+D/E)(RM – Rf)
Quiz – February 28Company A’s D/E=.6; the beta of
its assets is 1.2; expected market return is 13% and the risk free rate is 3%. What is the required return on company A’s equity?
If there are no taxes and RD = .08, what is the Company’s weighted average cost of capital?
16-21
16-22
Case II – With Corporate Taxes
Interest is tax deductible
The reduction in taxes increases the cash flow of the firm
Interest tax shield = The tax saving attained by a firm from
interest expense
Case II, example (1)
Unlevered Firm
Levered Firm
EBIT 5000 5000
Interest 0 500
Taxable Income
5000 4500
Taxes 1700 1530
Net Income 3300 2970
CFFA 3300 3470
23
16-24
Case II, example (2)Assume the company has $6,250, 8%
coupon debt and faces a 34% tax rate.Annual interest tax shield
◦ Tax rate times interest payment:
◦ Annual tax shield = 170Present value of annual interest tax
shield:◦ PV = 170/.08
16-25
Case II – Proposition IThe 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
◦Value of equity = Value of the firm – Value of debt
◦VU = EBIT(1-T) / RU
◦VL = VU + DTC
16-26
Case II – Proposition I, example
◦EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%
VU =25*.65/.12=
VL
E=
16-27
Case II – Proposition IIThe WACC decreases as D/E
increases because of the government subsidy on interest payments◦WACC = (E/V)RE + (D/V)(RD)(1-TC)◦RE = RU + (RU – RD)(D/E)(1-TC)
Example◦RE = .12 + (.12-.09)(75/86.67)(1-.35) =
13.69%◦WACC = (86.67/161.67)(.1369) +
(75/161.67)(.09) (1-.35)WACC = 10.05%
16-28
Case II – Proposition II, exampleSuppose that the firm changes its
capital structure so that the D/E ratio = 1.
What will happen to the cost of equity under the new capital structure?
What will happen to the weighted average cost of capital?
16-29
Case III – with Bankruptcy Costs
As the D/E ratio increases, the probability of bankruptcy increases
At some point, the additional value of the interest tax shield will be offset by the 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
16-30
Bankruptcy Costs(Financial distress costs)Direct costs
◦Legal and administrative costs◦Ultimately cause bondholders to incur
additional losses◦Disincentive to debt financing
Indirect costs◦The difficulties of running business that
is experiencing financial distress◦Examples: potentially fruitful programs
are dropped, employees are leaving the company
16-31
Static Theory of Capital StructureA firm borrows 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
At this point the firm’s WACC is minimized
16-32
Static Theory and Firm Value
16-33
Extended Pie Model
16-34
The Value of the FirmValue of the firm = marketed claims +
non-marketed claims◦Marketed - claims of stockholders and
bondholders◦Non-marketed - claims of the government
and other potential stakeholdersThe overall value of the firm is
unaffected by changes in capital structure
The division of value between marketed claims and non-marketed claims may be impacted by capital structure decisions
16-35
Observed Capital Structures
Capital structure differ by industry
There is a connection between different industry’s operating characteristics and capital structure
Firms and lenders look at the industry’s debt/equity ratio as a guide