FINANCIAL LEVERAGE AND

CAPITAL STRUCTURE
POLICY

Chapter 16 Reem Alnuaim

 Course Roadmap
Chapter Topic Focus Exam

15 Raising Capital All

14 Cost of Capital All

9 Net Present Value and Other All Mid-Term

Investment Criteria
11 Project Analysis and Evaluation All

16 Financial Leverage and Capital All

Structure Policy
10 Making Capital Investment All Mid-Term
Decision
17 Dividends Theory All
Capital Restructuring

 What is meant by capital restructuring

 What is the primary goal of financial
managers?
 Can leverage help in achieving such goals?
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
 The firm can increase leverage by issuing debt and
repurchasing outstanding shares
 The firm can decrease leverage by issuing new shares and
retiring outstanding debt
Capital Restructuring
 How should a firm go about choosing its debt–
equity ratio?
 We assume that the guiding principle is to choose
the course of action that maximizes the value of a
share of stock.
 When it comes to capital structure decisions, this is
essentially the same thing as maximizing the value
of the whole firm, and, for convenience, we will
tend to frame our discussion in terms of firm value
FIRM VALUE AND STOCK VALUE: AN
EXAMPLE
 The following example illustrates that the capital structure that
maximizes the value of the Firm is the one financial managers should
choose for the shareholders, so there is no conflict in our goals.
 To begin, suppose the market value of the J.J. Sprint Company is
$1,000.
 The company currently has no debt, and J.J. Sprint’s 100 shares sell
for $10 each.
 Further suppose that J.J. Sprint restructures itself by borrowing $500
and then paying out the proceeds to shareholders as an extra dividend
of $500/ 100 = $5 per share.
 This restructuring will change the capital structure of the firm with no
direct effect on the firm’s assets.
 The immediate effect will be to increase debt and decrease equity
 for ease of presentation, we describe the impact of
leverage in terms of its effects on earnings per share,
EPS, and return on equity, ROE.
 These are, of course, accounting numbers and, as
such, are not our primary concern.
 Using cash flows instead of these accounting
numbers would lead to precisely the same
conclusions, but a little more work would be needed.
We discuss the impact on market values in a
subsequent section.
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 the
value of the firm or minimizing the WACC
Financial Leverage

 The extent to which a firm relies on debt

 The more debt financing a firm uses in its
capital structure, the more financial leverage it
employs
Break-Even EBIT

 Find EBIT where EPS is the same under both the

current and proposed capital structures
 If we expect EBIT to be greater than the break-even
point, then leverage is beneficial to our stockholders
 If we expect EBIT to be less than the break-even
point, then leverage is detrimental to our stockholders
Ex 1 Page 569
 Maynard, Inc., has no debt outstanding and a total market value of 250,000$. EBIT are
projected to be 28,000$ if economic conditions are normal. If there is strong expansion
in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT
will be 50 percent lower. Maynard is considering a 90,000$ debt issue with a 7 percent
interest rate. The proceeds will be used to repurchase a share of stock. There are
currently 5,000 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 the economy goes with recapitalization. What do you
observe?
Ex 4 Page 542
 James Corporation is comparing two different capital structures: an all
equity plan (plan I) and a levered plan (plan II). Under plan I, the
company would have 160,000 shares of stock outstanding. Under plan
II, there would be 80,000 shares of stock outstanding and 2.8$ million
in debt outstanding. The interest rate on the debt is 8 percent and there
are no taxes.

A. If EBIT is 350,000$, which plan will result in the higher EPS?

B. If EBIT is 500,000$, which plan will result in the higher EPS?

C. What is the break-even EBIT?

Corporate borrowing & home made leverage

 homemade leverage: The use of personal

borrowing to change the overall amount of
financial leverage to which the individual is
exposed.
Proposed Capital Structure versus Original Capital
Structure with Homemade Leverage
Proposed Capital Structure versus Original
Capital Structure with Homemade Leverage

 This example demonstrates that investors can

always increase financial leverage themselves to
create a different pattern of payoffs. It thus makes
no difference whether Trans Am chooses the
proposed capital structure.
Unlevering the Stock
suppose management adopts the proposed capital structure.
Further suppose that an investor who owned 100 shares preferred the
original capital structure.
Show how this investor could “unlever” the stock to recreate the original
payoffs.
To create leverage, investors borrow on their own. To undo leverage,
investors must lend money.
In the case of Trans Am, the corporation borrowed an amount equal to
half its value. The investor can unlever the stock by simply lending
money in the same proportion.
In this case, the investor sells 50 shares for $1,000 total and then lends
the $1,000 at10 percent. The payoffs are calculated in the following
table:
Capital Structure and the Cost of Equity Capital

 Modigliani and Miller (M&M)Theory of Capital

Structure
 Proposition I – firm value
 Proposition II – WACC
 The value of the firm is determined by the cash flows
to the firm and the risk of the assets
 Changing firm value
 Change the risk of the cash flows
 Change the cash flows
Capital Structure Theory Under Three Special
Cases

 Case I – Assumptions
 No corporate or personal taxes

 No bankruptcy costs

 Case II – Assumptions
 Corporate taxes, but no personal taxes

 No bankruptcy costs

 Case III – Assumptions

 Corporate taxes, but no personal taxes

 Bankruptcy costs
Modigliani and Miller (M&M)Theory

 The proposition that the value of the firm is

independent of the firm’s capital structure.
 THE PIE MODEL
 One way to illustrate M&M Proposition I is to
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.
Figure 16.2
 In this case,
 we can view the capital structure question in terms
of a “pie” model.
Figure 16.2
 gives two possible ways of cutting up the
 pie between the equity slice, E , and the debt slice,
D : 40%–60% and 60%–40%.
 However, the size of the pie in Figure 16.2 is the
same for both firms because the value of the assets
is the same.
 This is precisely what M&M Proposition I states:
The size of the pie doesn’t depend on how it is
sliced.
Case I – Propositions I and II
 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
Case I - Equations
 WACC = RA = (E/V)RE + (D/V)RD

 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
Business Risk and
Financial Risk

 the systematic risk of the stock depends on:

 Systematic risk of the assets, A, (Business risk)

 Level of leverage, D/E, (Financial risk)

The Cost of Equity Capital
Example:16.3
The CAPM, the SML and Proposition II

 How does financial leverage affect systematic risk?

 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
 Replace RA with the CAPM and assume that the debt is riskless (RD =
Rf)
 RE = Rf + A(1+D/E)(RM – Rf)
Business Risk and
Financial Risk

 RE = Rf + A(1+D/E)(RM – Rf)
 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)
Business Risk and
Financial Risk

 The total systematic risk of the firm’s equity has

two parts:
 Business risk and Financial risk.
 The first part (the business risk) depends on the
firm’s assets and operations and is not affected by
capital structure.
 The second part (the financial risk) is completely
determined by financial policy.
Case I - Example
 Data
 Required return on assets(RA) = 16%; cost of debt(RD) = 10%;
percent of debt = 45%
 What is the cost of equity(RE)?
 RE = RA + (RA – RD)(D/E)
 RE = 16 + (16 - 10)(.45/.55) = 20.91%
 Suppose instead that the cost of equity is 25%, what is the
debt-to-equity ratio?
 RE = RA + (RA – RD)(D/E)
 25 = 16 + (16 - 10)(D/E)
 D/E = (25 - 16) / (16 - 10) = 1.5
Case II – Cash Flow
 Interest is tax deductible
 Therefore, when a firm adds debt, it reduces taxes,
all else equal
 The reduction in taxes increases the cash flow of
the firm
 How should an increase in cash flows affect the
value of the firm?
Case II - Example
Interest Tax Shield
 Annual interest tax shield
 Tax rate times interest payment.
 6,250 in 8% debt = 500 in interest expense
 Annual tax shield = .34(500) = 170
 Present value of annual interest tax shield
 Assume perpetual debt for simplicity
 PV = 170 / .08 = 2,125
 PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125
Example page 547
 We see from the result that capital structure has some effect because the cash
flow from U and L is not the same, even thought the two firms have identical
assets.

The fact that interest is deductible for tax purposes has generated
a tax saving = interest payment ($80) * tax rate (0.30) = $24 = interest tax shield
Case II – Proposition I
 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
Example: Case II – Proposition I
 Data
 EBIT = 25 million; Tax rate = 35%; Debt = $75 million;
Cost of debt = 9%; Unlevered cost of capital = 12%
 VU = EBIT(1-T) / RU
 VU = 25(1-.35) / .12 = $135.42 million
 VL = VU + DTC
 VL = 135.42 + 75(.35) = $161.67 million
 E = 161.67 – 75 = $86.67 million
Case II – Proposition II
 The WACC decreases as D/E increases because of
the government subsidy on interest payments
 Wacc = RA = (E/V)RE + (D/V)(RD)(1-TC)
 RE = RU + (RU – RD)(D/E)(1-TC)
 Example
 RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
 RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35)
RA = 10.05%
Example:16.4
Example: Case II – Proposition II
 Suppose that the firm changes its capital structure so
that the debt-to-equity ratio becomes 1.
 What will happen to the cost of equity under the new
capital structure?
 RE = 12 + (12 - 9)(1)(1-.35) = 13.95%
 What will happen to the weighted average cost of
capital?
 RA = .5(13.95) + .5(9)(1-.35) = 9.9%
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
 At some point, the additional value of the interest tax
shield will be offset by the increase in 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
Bankruptcy Costs
 Direct costs
 Legal and administrative costs
 Ultimately cause bondholders to incur additional losses
 Disincentive to debt financing
 Financial distress
 Significant problems in meeting debt obligations
 Firms that experience financial distress do not necessarily
file for bankruptcy
More Bankruptcy Costs
 Indirect bankruptcy costs
 Larger than direct costs, but more difficult to measure and estimate
 Stockholders want to avoid a formal bankruptcy filing
 Bondholders want to keep existing assets intact so they can at least
receive that money
 Assets lose value as management spends time worrying about avoiding
bankruptcy instead of running the business
 The firm may also lose sales, experience interrupted operations and
lose valuable employees
Conclusions
 Case I – no taxes or bankruptcy costs
 No optimal capital structure
 Case II – corporate taxes but no bankruptcy costs
 Optimal capital structure is almost 100% debt
 Each additional dollar of debt increases the cash flow 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
Managerial Recommendations
 The tax benefit is only important if the firm has a
large tax liability
 Risk of financial distress
 The greater the risk of financial distress, the less debt will
be optimal for the firm
 The cost of financial distress varies across firms and
industries, and as a manager you need to understand the
cost for your industry