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Leverage and Capital Structure

Chapter 13

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Chapter Outline

1. The Effect of Financial Leverage

2. Capital Structure Theoryi. Case I – Cost of Equity

ii. Case II- Cash Flow and Taxes

iii. Case III – Bankruptcy Costs

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1. 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

Increase leverage by issuing debt and repurchasing outstanding shares

Decrease leverage by issuing new shares and retiring outstanding debt

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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 firm value or minimizing WACC

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The Effect of Leverage How 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

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Example: Financial Leverage, EPS and ROE We will ignore the effect of taxes at this stage What happens to EPS and ROE when we issue

debt and buy back shares of stock?Current Proposed

Assets $8,000,000 $8,000,000Debt $0 $4,000,000Equity $8,000,000 $4,000,000Debt/Equity Ratio 0 1Share Price $20 $20Shares Outstanding 400,000 200,000Interest rate 10% 10%

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Example: Financial Leverage, EPS and ROE

Recession Expected ExpansionEBIT $500,000 $1,000,000 $1,500,000Interest 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

Current Capital Structure: No Debt

Recession Expected ExpansionEBIT $500,000 $1,000,000 $1,500,000Interest 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

Proposed Capital Structure: Debt = $4 million

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Example: Financial Leverage, EPS and ROE 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

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2. Capital Structure Theory Modigliani and Miller Theory of Capital Structure

Proposition I – firm value Proposition II – WACC

The value of the firm is determined by the amount of cash flows generated by the firm(/project) and the risk level of the cash flows from assets

Change in firm value will be caused by Change in the amount of the cash flows Change in the risk of the cash flows

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Capital Structure Theory Under Three Special Cases Case I – Assumptions

No corporate taxes No bankruptcy costs

Case II – Assumptions Corporate taxes No bankruptcy costs

Case III – Assumptions Corporate taxes Bankruptcy costs

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2.1 Case I – M&M Proposition

Proposition I The value of the firm is NOT affected by changes in

the capital structure The amount and risk of cash flow from assets do not

change, therefore value doesn’t change Proposition II

The WACC of the firm is NOT affected by capital structure

The cost of equity is a positive linear function of capital structure.

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Case I – M&M Proposition II

WACC = RA = (E/V)RE + (D/V)RD

Cost of Equity: RE = RA + (RA – RD)(D/E)

RA is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets

(RA – RD)(D/E) is the “cost” of the firm’s financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage

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Figure 13.6

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2.2 Case II – Cash Flows and 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

amount How should an increase in cash flow amount

affect the value of the firm?

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Case II - Example

Unlevered Firm Levered Firm

EBIT 5000 5000

Interest 0 500

Taxable Income 5000 4500

Taxes (34%) 1700 1530

Net Income 3300 2970

CFFA 3300 3470

Borrow $6250 with 8% interest rate

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Interest Tax Shield Annual interest tax shield

Tax rate times interest payment $500 in interest expense Annual tax shield = .34(500) = 170

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Case II-M&M Proposition I

Proposition I When considering taxes, the value of the firm will

increase as total debt increases because of the interest tax shield

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2.3 Case III Now we add bankruptcy costs As the D/E ratio increases, the probability of

bankruptcy increases This increased probability will increase the expected

bankruptcy costs, thus increase business risk 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

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Case III-M&M Proposition I

Proposition I With taxes and bankruptcy costs, the value of the

firm reaches a maximum level at the optimal borrowing point

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Bankruptcy Costs

Direct costs Legal and administrative costs Ultimately cause bondholders to incur additional

losses Financial distress

Significant problems in meeting debt obligations Most firms that experience financial distress do not

ultimately file for bankruptcy

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2.4 Optimal Capital Structure Case I – no taxes or bankruptcy costs

No optimal capital structure Case II – corporate taxes but no bankruptcy costs

Optimal capital structure is 100% debt Each additional dollar of debt increases the cash

flow amount 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

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Review Questions1. What is the effect of leverage on EPS and ROE?2. What is the effect of leverage on cost of equity? What are the

two components of equity risk? What is the effect of leverage on cash flow? How to calculate interest tax shield?What do M&M proposition I and II argue about for the case when there is no taxes and bankruptcy costs? What does M&M proposition I argue about for case with only taxes and for case with both taxes and bankruptcy costs?What is the impact of taxes on capital structure choice? What is the impact of bankruptcy costs on capital structure choice? What is the optimal capital structure in the three cases that are discussed in this chapter?