Chapter 16 Financial Leverage and Capital Structure Policy

# Chapter 16 Financial Leverage and Capital Structure Policy

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## Chapter 16 Financial Leverage and Capital Structure Policy

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1. Chapter 16Financial Leverage and Capital Structure Policy • 16.1 The Capital Structure Question • 16.2 The Effect of Financial Leverage • 16.3 Capital Structure and the Cost of Equity Capital • 16.4 M&M Propositions I and II with Corporate Taxes • 16.5 Bankruptcy Costs • 16.6 Optimal Capital Structure • 16.7 The Pie Again • 16.8 Observed Capital Structures • 16.9 Summary and Conclusions Vigdis Boasson Mgf301, school of Management, SUNY at Buffalo

2. 16.4 Example: Computing Break-Even EBIT • Ignoring taxes: A. With no debt: EPS = EBIT/500,000 B. With \$2,5000,000 in debt at 10%: EPS = (EBIT - \$___________)/250,000 C. These are equal when: EPSBE = EBITBE/_______= (EBITBE - \$250,000)/250,000 D. With a little algebra: EBITBE = \$500,000 So EPSBE = \$________/share

3. 16.5 Financial Leverage, EPS and EBIT EPS (\$) 3 2.5 2 1.5 1 0.5 0 – 0.5 – 1 D/E = 1 D/E = 0 EBIT (\$ millions, no taxes) 0 0.2 0.4 0.6 0.8 1

4. 16.6 Example: Homemade Leverage and ROE • Firm does not adopt proposed capital structureInvestor put up \$500 and borrows \$500 to buy 100 shares EPS ofunlevered firm \$0.60 \$1.30 \$1.60 Earnings for100 shares \$60.00 \$130.00 \$160.00 less interest on\$500 at 10% \$50.00 \$50.00 \$50.00 Net earnings \$10.00 \$80.00 \$110.00 ROE 2% 16% 22%

5. 16.6 Homemade Leverage: An Example (concluded) • Firm adopts proposed capital structureInvestor puts up \$500, \$250 in stock and \$250 in bonds EPS oflevered firm \$0.20 \$1.60 \$2.20 Earnings for25 shares \$5.00 \$40.00 \$55.00 plus interest on\$250 at 10% \$25.00 \$25.00 \$25.00 Net earnings \$30.00 \$65.00 \$80.00 ROE 6% 13% 16%

6. 16.7 Milestones in Finance: The M&M Propositions • Financial leverage and firm value: Proposition I Since investors can costlessly replicate the financing decisions of the firm (remember “homemade leverage”?), in the absence of taxes and other unpleasantries, the value of the firm is unaffected by its capital structure.

7. 16.7 Milestones in Finance: The M&M Propositions (concluded) The cost of equity and financial leverage: Proposition II • A. Because of Prop. I, the WACC must be constant. With no taxes, WACC = RA = (E/V) RE + (D/V) RD where RA is the return on the firm’s assets • B. Solve for RE to get MM Prop. II RE = RA + (RA - RD) (D/E) ( ) Cost of equity has two parts: 1. RA and “business” risk 2. D/E and “financial” risk

8. 16.8 The Cost of Equity and the WACC (Figure 16.3) Cost of capital RE = RA + (RA – RD) x (D/E) WACC = RA RD Debt-equity ratio, D/E

9. 16.9 The CAPM, the SML, and Proposition II M&M Proposition II: RE = RA + (RA - RD) (D/E) CAPM: RE = RF + (RM - RF) E RA = RF + (RM - RF) A, where A is the beta of the firm’s assets. What is the relationship between debt and systematic risk?

10. 16.10 Business Risk and Financial Risk • Systematic risk and financial leverage Assume the debt is riskless, so that RD = RF, and substitute for RA in Prop. II: RE = RF + (RM - RF) A (1 + D/E) ( ) E = A (1 + D/E) = A + A D/E ( ) Systematic risk for the firm’s stock has two parts: 1. A and “business” risk 2. D/E and “financial” risk

11. 16.11 Debt, Taxes, and Firm Value • The interest tax shield and firm value For simplicity: (1) perpetual cash flows (2) no depreciation (3) no fixed asset or NWC spending A firm is considering going from zero debt to \$400 at 10%: Firm U Firm L (unlevered) (levered) EBIT \$200\$200 Interest 0\$40 Tax (40%) \$80\$64 Net income \$120\$96 Cash flowfrom assets \$120\$_____ Tax saving = \$16 = ______ \$40 = TC RD D

12. 16.11 Debt, Taxes, and Firm Value (concluded) • What’s the link between debt and firm value? Since interest creates a tax deduction, borrowing creates a tax shield. Its value is added to the value of the firm. • MM Proposition I (with taxes) PV(tax saving) = \$16/________ = \$________ = (TC RD D)/RD = TC D VL = VU + TC D

13. 16.12 Example: Debt, Taxes, and the WACC • Taxes and firm value: an example • EBIT = \$100 • TC = 30% • RU = 12.5% Q. Suppose debt goes from \$0 to \$100 at 10%, what happens to equity value, E? VU = \$100 (________________)/.125 = \$560 VL = \$560 + .30 \$________ = \$590, so E = \$________.

14. 16.12 Example: Debt, Taxes, and the WACC (concluded) • WACC and the cost of equity (MM Proposition II with taxes) With taxes: RE = RU + (RU - RD) (D/E) (1 - TC ) RE = _____+ (_____- .10) (_____/_____) (1 - .30) = 12.86% WACC = (____/____) .1286 + (100/590) .10 (1 - .30) = 11.86% ( ) The WACC decreases as more debt financing is used. Optimal capital structure is all debt!

15. 16.13 Taxes, the WACC, and Proposition II Cost of capital RE P WACC RD (1 – TC) Debt-equity ratio, D/E

16. 16.14 Modigliani and Miller Summary (Table 16.6) • I. The No-Tax Case A. Proposition I: The value of the firm levered equals the value of the firm unlevered: VL = VU Implications of Proposition I: 1. A firm’s capital structure is irrelevant. 2. A firm’s WACC is the same no matter what mix of debt and equity is used. B. Proposition II: The cost of equity, RE, is RE = RA + (RA - RD) D/E where RA is the WACC, RD is the cost of debt, and D/E is the debt/equity ratio. C. Implications of Proposition II 1. The cost of equity rises as the firm increases its use of debt financing. 2. The risk of equity depends on the risk of firm operations and on the degree of financial leverage.

17. 16.14 Modigliani and Miller Summary (Table 16.6) (concluded) • II. The Tax Case A. Proposition I with Taxes: The value of the firm levered equals the value of the firm unlevered plus the present value of the interest tax shield: VL = VU +TcD where Tc is the corporate tax rate and D is the amount of debt. B. Implications of Proposition I: 1. Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is 100 percent debt. 2. A firm’s WACC decreases as the firm relies more heavily on debt.

18. 16.15 The Optimal Capital Structure and the Value of the Firm (Figure 16.6) Value ofthe firm(VL) VL = VU + TCD Present value of taxshield on debt Financial distress costs Maximumfirm value VL* Actual firm value VU VU = Value of firm with no debt Debt-equity ratio, D/E D/E Optimal amount of debt

19. 16.16 The Optimal Capital Structure and the Cost of Capital (Figure 16.7) Cost ofcapital(%) RE RU RU WACC Minimum cost of capital RD (1 – TC) WACC* Debt/equity ratio (D/E) D*/E*The optimal debt/equity ratio

20. 16.17 The Extended Pie Model Lower financial leverage Higher financial leverage Bondholderclaim Bondholderclaim Stockholder claim Bankruptcyclaim Stockholder claim Bankruptcyclaim Taxclaim Taxclaim

21. 16.18 Chapter 16 Quick Quiz 1. Why does the firm’s cost of equity increase with leverage? 2. What are direct bankruptcy costs? 3. What kinds of firms would be most likely to suffer indirect bankruptcy costs? 4. Name three types of financial distress.

22. 16.19 Solution to Problem 16.1 • Probit, Inc. has no debt and a total market value (MV) of \$70,000. EBIT is projected to be \$4,000 if economic conditions are normal. EBIT is expected to be 30% higher if the economy is strong, or 60% lower if a recession occurs. Probit is considering a \$35,000 debt issue with a 4%coupon. The proceeds will be used to repurchase outstanding stock. There are now 2,000 shares outstanding. Ignore taxes for this problem. a. Calculate EPS under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession. b. Repeat part (a) assuming that Probit goes through with the recapitalization. What do you observe?

23. 16.19 Solution to Problem 16.1 (continued) a. EBIT: \$1,600 \$4,000 \$____ Interest: 0 0 0 Taxes: 0 0 0 NI: \$____ \$4,000 \$____ EPS: \$ .80 \$2.00 \$2.60 EPS: -40% --- +30%

24. 16.19 Solution to Problem 16.1 (concluded) b. \$70,000/2,000 shares = \$35 per share \$35,000/\$35 = 1,000 shares bought back EBIT: \$1,600 \$4,000 \$5,200 Interest: ____ ____ ____ Taxes: 0 0 0 NI: \$200 \$2,600 \$3,800 EPS: \$0.20 \$2.60 \$3.80  EPS: -92.31% --- +46.15%