Chapter 16 Financial Leverage and Capital Structure Policy 16-1 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline •The Capital Structure Question •The Effect of Financial Leverage •Capital Structure and EBIT •M&M Propositions I and II with Corporate Taxes •Bankruptcy Costs 16-2 Chapter Outline (continued) • The Optimal Capital Structure • The Pie Again • The Pecking-Order Theory • Observed Capital Structures • A Quick Look at the Bankruptcy Process 16-3 Chapter Outline • The Capital Structure Question • The Effect of Financial Leverage • Capital Structure and EBIT • M&M Propositions I and II with Corporate Taxes • Bankruptcy Costs 16-4 Capital Restructuring Definition: Capital Structure is the amount of debt and the amount of equity a firm uses as its sources of capital 16-5 Capital Restructuring Definition: Leverage is the use of financial debt The concept of leverage is just like that in physics where a small change in one thing has a big effect in another thing 16-6 Capital Restructuring We are going to look at how changes in capital structure impact 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 16-7 Capital Restructuring The firm can increase leverage by issuing debt and/or repurchasing outstanding shares The firm can decrease leverage by issuing new shares and/or retiring outstanding debt 16-8 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 16-9 We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC Chapter Outline •The Capital Structure Question •The Effect of Financial Leverage •Capital Structure and EBIT •M&M Propositions I and II with Corporate Taxes •Bankruptcy Costs 16-10 Bankruptcy Process – Part I •Business failure – business has terminated with a loss to creditors •Legal bankruptcy – petition federal court for bankruptcy •Technical insolvency – firm is unable to meet debt obligations •Accounting insolvency – book value of equity is negative 16-73 Bankruptcy Process – Part II • Liquidation •Chapter of the Federal Bankruptcy Reform Act of 1978 •Trustee takes over assets, sells them and distributes the proceeds according to the absolute priority rule 16-74 Bankruptcy Process – Part II • Reorganization •Chapter 11 of the Federal Bankruptcy Reform Act of 1978 •Restructure the corporation with a provision to repay creditors 16-75 Work the Web You can find information about a company’s capital structure relative to its industry, sector and the S&P 500 at Reuters Click on the web surfer to go to the site Choose a company and get a quote Choose “Ratio Comparisons” 16-76 Quick Quiz  Explain the effect of leverage on EPS and ROE  What is the break-even EBIT, and how we compute it?  How 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? 16-77 Comprehensive Problem Assuming 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% 16-78 Ethics Issues  Suppose managers of a firm know that the company is approaching financial distress  Should the managers borrow from creditors and issue a large one-time dividend to shareholders?  How might creditors control this potential transfer of wealth? 16-79 Terminology • Capital Structure • Leverage • M&M’s Propositions I and II • Interest Tax Shield • Bankruptcy • Optimal Capital Structure 16-80 Formulas I Value of an Unlevered and Levered Firm: VU = EBIT(1-T) / RU VL = VU + DTC VE = VL - D The Present Value of a Tax Shield Perpetuity: PV = D(RD)(TC) / RD 16-81 Formulas II CAPM: RA = Rf + βA(RM – Rf) If we assume debt is riskless (RD = Rf) then, RE = Rf + βA(1+D/E)(RM – Rf) If we let βA(1+D/E) = βE then, the CAPM becomes: RE = Rf + βE(RM – Rf) 16-82 Formulas III In a world of no corporate taxes: WACC = RA = (E/V)RE + (D/V)RD And the cost of equity (RE), is: RE = RA + (RA – RD)(D/E) In a world of corporate taxes: RA = (E/V)RE + (D/V)(RD)(1-TC) RE = RU + (RU – RD)(D/E)(1-TC) 16-83 Key Concepts and Skills •Describe what leverage is •How does leverage change the organization’s cash flow? •What is the impact of taxes on leverage? •What is the impact of corporate bankruptcy on leverage? •How does bankruptcy impact the shareholders? 16-84 What are the most important topics of this chapter? Leverage is the use of debt and it can help or hinder the firm’s ROE and EPS Debt has a tax advantage and as such more debt is better 16-85 Debt is risky so there is a maximum debt level to obtain the tax advantage without increasing the WACC What are the most important topics of this chapter? The likelihood of bankruptcy impacts the firm’s WACC M&M’s theories provide a framework to better understand the relationships of taxes, bankruptcy, firm value and the cost of capital 16-86 Questions? 16-87 [...]... uses $500 of her own to buy 100 shares of stock  Payoffs:  Recession: 100(0.60) - 1(500) = $10  Expected: 100(1.30) - 1(500) = $80  Expansion: 100(2.00) - 1(500) = $150  Mirrors the payoffs from purchasing 50 shares of the firm under the proposed capital structure 16-19 Proposed Capital Structure  Investor buys $250 worth of stock (25 shares) and $250 worth of bonds paying 10%  Payoffs:  Recession:... “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 16-26 Cost of Capital versus D/E Ratios 16-27 Proposition I + Case I Example 1 Data: Required return on assets = 16% cost of debt = 10% percent of debt = 45% What is the cost of equity?... numerator and the denominator so…) DTC = 6,250(.34) = 2,125 16-33 Proposition I + Case II The 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 (Assuming perpetual cash flows) VU = EBIT(1-T) / RU VL = VU + DTC 16-34 Proposition I + Case... Capital Structure Theory Proposition I – Firm value The value of the firm is determined by the cash flows to the firm and the risk of the assets The firm’s value will change due to: 1 The changing risk of the cash flows 2 The changing cash flows themselves (amounts and timing) 16-22 Under Three Special Cases Case I Case II Case III 16-23 • No Corporate or personal taxes • No bankruptcy costs • Corp taxes;... Effect of Leverage •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 16-11 The Effect of Leverage How does leverage impact the EPS and ROE of a... 20.91% Proposition I + Case I Example 2 Data: Required return on assets = 16% cost of debt = 10% percent of debt = 45% Suppose the cost of equity is 25% What is the Debt-to-Equity (D/E) ratio? RE = RA + (RA – RD)(D/E) 25 = 16 + (16 - 10) (D/E) D/E = 1.5 16-29 Proposition I – Firm Value Case I Case II Case III 16-30 • No Corporate or personal taxes • No bankruptcy costs • Corp taxes; no personal taxes... 1(250) = $100  Mirrors the payoffs from purchasing 50 shares under the current capital structure Chapter Outline • The Capital Structure Question • The Effect of Financial Leverage • Capital Structure and EBIT • M&M Propositions I and II with Corporate Taxes • Bankruptcy Costs 16-20 Capital Structure Theory Modigliani and Miller (M&M) have proposed a two-part “Theory of Capital Structure” Proposition... costs Proposition I – Firm Value Case I Case II Case III 16-24 • No Corporate or personal taxes • No bankruptcy costs • Corp taxes; no personal taxes • No bankruptcy costs • Corp taxes; no personal taxes • Bankruptcy costs Proposition I + Case 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 16-25... equal •The reduction in taxes increases the cash flow of the firm •How should an increase in cash flows change the value of the firm? 16-31 Interest Tax Shield I Annual interest tax shield = Tax rate times interest payment $6,250 in 8% debt = $500 in interest expense Annual tax shield = 34(500) = $170 16-32 Interest Tax Shield II Present value of annual interest tax shield: Assume perpetual debt for... Leverage amplifies the variation in both EPS and ROE A small change in leverage generates a large change in profits 16-12 Example: Financial Leverage, EPS and ROE: Part I (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? Financial Leverage Example 16-13 Example: Financial Leverage, EPS and ROE: Part II Variability in ROE ... amount of debt and the amount of equity a firm uses as its sources of capital 16-5 Capital Restructuring Definition: Leverage is the use of financial debt The concept of leverage is just like that... $500 of her own to buy 100 shares of stock  Payoffs:  Recession: 100(0.60) - 1(500) = $10  Expected: 100(1.30) - 1(500) = $80  Expansion: 100(2.00) - 1(500) = $150  Mirrors the payoffs from... 50 shares of the firm under the proposed capital structure 16-19 Proposed Capital Structure  Investor buys $250 worth of stock (25 shares) and $250 worth of bonds paying 10%  Payoffs:  Recession: