Strategic Finance Lec #6 Chp#14&16: Financial Leverage and Capital Structure Policy

FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY
Strategic Finance
Lec #6
CHp#14&16
The Cost of Capital: Some Preliminaries
• we developed the security market line, or SML, and used it to explore
the
• relationship between the expected return on a security and its
systematic risk.
• We concentrated on how the risky returns from buying securities looked
from the viewpoint of, for example, a shareholder in the firm. This
helped us understand more about the alternatives available to an
investor in the capital markets.
• In this chapter, we turn things around a bit and look more closely at the
other side of the problem, which is how these returns and securities look
from the viewpoint of the companies that issue them.
• The return an investor in a security receives is the cost of that security
to the company that issued it.
• required return/ appropriate discount rate /
and cost of capital
REQUIRED RETURN VERSUS COST OF
CAPITAL
• The cost of capital depends primarily on the
use of the funds, not the source.
• The investment will have a positive NPV only if its return
exceeds its required return
• firm must earn on the investment just to compensate its
investors for the use of the capital needed to finance the
project.
• This is why we could also say that 10 percent is the cost of
capital associated with the investment.
• To evaluate a risk free project We look at the capital
markets and observe the current rate offered by risk-free
investments, and we use this rate to discount the project’s
cash flows.
• The cost of capital for risky project, is greater than the risk-
free rate, and the appropriate discount rate would exceed
the risk-free rate.
• The key fact to grasp is that the cost of capital associated
with an investment depends on the risk of that
investment. This is one of the most important lessons in
corporate finance, so it bears repeating:
• Use of the terms required return, appropriate discount
rate, and cost of capital more or less interchangeably
because, as the discussion in this section suggests, they all
mean essentially the same thing.
The Cost of Equity
• The return that equity investors require on
their investment in the fi rm.
• THE DIVIDEND GROWTH MODEL APPROACH
P0 = D1 (1+g)/Re –g
Re= D1 / P0 - g
• Capital Asset Pricing Model

E( RE ) = Rf + b [E( R M ) - Rf ]
cost of debt
• The return that lenders require on the firm’s
debt.
• Yield to Maturity on Bond
Cost of preferred stock
• Rp = D/ P0
• WACC= (E/V )* R e + (P/V )* Rp + (D/V )* RD (1 -T C)
CAPITAL STRUCTURE AND THE COST OF
CAPITAL
• What happens to the cost of capital when we
vary the amount of debt financing, or the
debt–equity ratio
• The value of the firm is maximized when the WACC is
minimized.
• WACC is the appropriate discount rate for the firm’s overall

cash flows.
• Because values and discount rates move in opposite

directions, minimizing the WACC will maximize the value of
the firm’s cash flows. Thus, we will want to choose the
firm’s capital structure so that the WACC is minimized.
• For this reason, we will say that one capital
structure is better than another if it results in
a lower weighted average cost of capital.
Further, we say that a particular debt–equity
ratio represents the optimal capital structure
if it results in the lowest possible WACC. This
optimal capital structure is sometimes called
the firm’s target capital structure as well.
The Effect of Financial Leverage
• Example: excel
CORPORATE BORROWING AND HOMEMADE
LEVERAGE
1. The effect of financial leverage depends on the company’s
EBIT. When EBIT is relatively high, leverage is beneficial.
2. Under the expected scenario, leverage increases the returns
to shareholders, as measured by both ROE and EPS.
3. Shareholders are exposed to more risk under the proposed
capital structure because the EPS and ROE are much more
sensitive to changes in EBIT in this case.
4. Because of the impact that financial leverage has on both
the expected return to stockholders and the riskiness of the
stock, capital structure is an important consideration.
NO
• The reason is that shareholders can adjust the
amount of financial leverage by borrowing and
lending on their own.
• This use of personal borrowing to alter the
degree of financial leverage is called
homemade leverage .
• Example :excel
Capital Structure and the Cost of Equity
Capital
M&M PROPOSITION I: THE PIE MODEL
• M&M Proposition I:
• Imagine two firms that are identical on the left
side of the balance sheet.
• Their assets and operations are exactly the same.
• The right sides are different because the two
firms finance their operations differently.
• In this case, we can view the capital structure
question in terms of a “pie” model.
THE COST OF EQUITY AND FINANCIAL
LEVERAGE: M&M PROPOSITION II
• M&M Proposition II: The proposition that a
firm’s cost of equity capital is a positive linear
function of the firm’s capital structure.
• Although changing the capital structure of the
firm does not change the firm’s total value, it
does cause important changes in the firm’s debt
and equity.
• We now examine what happens to a firm
financed with debt and equity when the debt–
equity ratio is changed.
• To simplify our analysis, we will continue to
ignore taxes.
• If we ignore taxes, the weighted average cost of
capital, WACC, is:
• WACC= (E/V )* R e + (D/V )* RD
• V= E+D
• It can be re-written as WACC is overall return on
firms assets;
• RA = (E/V )* R e + (D/V )* RD
• Re arrange the equation for cost of equity;
• R e = RA + (RA - RD )* D/E
• M&M Proposition II , which tells us that the
cost of equity depends on three things: the
required rate of return on the firm’s assets,
• RA ; the firm’s cost of debt, RD ; and the
firm’s debt–equity ratio, D / E .
M&M Propositions I and II with Corporate
Taxes
• Debt has two distinguishing features:
– interest paid on debt is tax deductible. This is good
for the firm, and it may be an added benefi t of
debt financing.
– Second, failure to meet debt obligations can
result in bankruptcy. This is not good for the firm,
and it may be an added cost of debt financing.
THE INTEREST TAX SHIELD
• Excel: example
• For levered and unlevered firm
TAXES AND M&M PROPOSITION I
• Present value of the interest tax shield
• PV= Tc* D* Rd/Rd
• We have now come up with another famous
result, M&M Proposition I with corporate taxes.
We have seen that the value of Firm L, exceeds
the value of Firm U, by the present value of the
interest tax shield, T C * D.
• M&M Proposition I with taxes therefore states
that: V L = V U + T C*D
• Figure: page 534
TAXES, THE WACC, AND PROPOSITION II
• Figure: page 535

Optimal capital Structure
• A firm will borrow because the interest tax shield is valuable. At

relatively low debt levels, the probability of bankruptcy and
financial distress is low, and the benefi t from debt outweighs
the cost.
• At very high debt levels, the possibility of fi nancial distress is a
chronic, ongoing problem for the fi rm, so the benefit from debt
fi nancing may be more than offset by the fi nancial distress
costs.
• Based on our discussion, it would appear that an optimal
capital structure exists somewhere in between these extremes.
•
THE STATIC THEORY OF CAPITAL STRUCTURE
• T he theory of capital structure that we have outlined is

called the static theory of capital structure. It says
that firms borrow 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.
• We call this the static theory because it assumes that the
firm is fixed in terms of its assets and operations and it
considers only possible changes in the debt–equity ratio.
• Fig16.6
OPTIMAL CAPITAL STRUCTURE AND THE
COST OF CAPITAL
• The capital structure that maximizes the value
of the firm is also the one that minimizes the
cost of capital.
OPTIMAL CAPITAL STRUCTURE: A RECAP
• Fig 16.8

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FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY

• Capital Asset Pricing Model

• WACC is the appropriate discount rate for the firm’s overall

• Because values and discount rates move in opposite

• Figure: page 535

• A firm will borrow because the interest tax shield is valuable. At

• T he theory of capital structure that we have outlined is

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