17

Financial Leverage and Capital

Structure Policy

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 Key Concepts and Skills
 Understand the effect of financial leverage
on cash flows and the cost of equity
 Understand the impact of taxes and
bankruptcy on capital structure choice
 Understand the basic components of the
bankruptcy process

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 Chapter Outline
 The Capital Structure Question
 The Effect of Financial Leverage
 Capital Structure and the Cost of Equity Capital
 M&M Propositions I and II with Corporate Taxes
 Bankruptcy Costs
 Optimal Capital Structure
 The Pie Again
 Observed Capital Structures
 A Quick Look at the Bankruptcy Process

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 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

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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 the value of the firm or minimizing
the 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 – 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

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 Example: Financial Leverage,
EPS and ROE – Part II
 Variability in ROE
 Current: ROE ranges from 6% to 20%
 Proposed: ROE ranges from 2% to 30%
 Variability in EPS
 Current: EPS ranges from $0.60 to $2.00
 Proposed: EPS ranges from $0.20 to $3.00
 The variability in both ROE and EPS increases
when financial leverage is increased

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 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

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Example: Break-Even EBIT
EBIT EBIT  250,000

500,000 250,000
 500,000 
EBIT    EBIT  250,000 
 250,000 
EBIT  2EBIT  500,000
EBIT  $500,000
500,000
EPS   $1.00
500,000 Break-even Graph

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Example: Homemade Leverage and
ROE
 Current Capital Structure  Proposed Capital Structure
 Investor borrows $500 and  Investor buys $250 worth of
uses $500 of her own to buy stock (25 shares) and $250
100 shares of stock worth of bonds paying 10%.
 Payoffs:  Payoffs:
 Recession: 100(0.60) - .1(500)  Recession: 25(.20) + .1(250) =
= $10 $30
 Expected: 100(1.30) - .1(500)  Expected: 25(1.60) + .1(250) =
= $80 $65
 Expansion: 100(2.00) - .1(500)  Expansion: 25(3.00) + .1(250) =
= $150 $100
 Mirrors the payoffs from  Mirrors the payoffs from
purchasing 50 shares from the purchasing 50 shares under the
firm under the proposed capital current capital structure
structure

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 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 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

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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

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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

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 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

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Figure 17.3

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 Case I - Example
 Data
 Required return on assets = 16%, cost of debt = 10%;
percent of debt = 45%
 What is the cost of equity?

RE = 16 + (16 - 10)(.45/.55) = 20.91%
 Suppose instead that the cost of equity is 25%, what is
the debt-to-equity ratio?
 25 = 16 + (16 - 10)(D/E)
 D/E = (25 - 16) / (16 - 10) = 1.5
 Based on this information, what is the percent of equity
in the firm?
 E/V = 1 / 2.5 = 40%

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 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)

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 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)

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 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?

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 Case II - Example
Unlevered Firm Levered Firm

EBIT 5,000 5,000

Interest 0 500
Taxable Income 5,000 4,500

Taxes (34%) 1,700 1,530

Net Income 3,300 2,970
CFFA 3,300 3,470

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 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

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 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

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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 = 25(1-.35) / .12 = $135.42 million
 VL = 135.42 + 75(.35) = $161.67 million
 E = 161.67 – 75 = $86.67 million

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Figure 17.4

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 Case II – Proposition II
 The WACC decreases as D/E increases
because of the government subsidy on interest
payments
 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%

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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%

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Figure 17.5

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 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

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 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
 Most firms that experience financial distress do not
ultimately file for bankruptcy

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 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

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Figure 17.6

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Figure 17.7

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 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

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Figure 17.8

35
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

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Figure 17.9

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 The Value of the Firm
 Value of the firm = marketed claims + nonmarketed
claims
 Marketed claims are the claims of stockholders and bondholders
 Nonmarketed claims are the claims of the government and other
potential stakeholders
 The overall value of the firm is unaffected by changes in
capital structure
 The division of value between marketed claims and
nonmarketed claims may be impacted by capital
structure decisions

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 Observed Capital Structure
 Capital structure does differ by industries
 Differences according to Cost of Capital 2004
Yearbook by Ibbotson Associates, Inc.
 Lowest levels of debt
• Drugs with 6.38% debt
• Paper and computers with 10.24 – 10.68% debt
 Highest levels of debt
• Airlines with 64.22% debt
• Electric utilities with 49.03% debt

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 Work the Web Example
 You can find information about a
company’s capital structure relative to its
industry, sector and the S&P 500 at
Reuters at Yahoo
 Click on the web surfer to go to the site
 Choose a company and get a quote
 Choose ratio comparisons

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 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

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 Bankruptcy Process – Part II
 Liquidation
 Chapter 7 of the Federal Bankruptcy Reform Act of
1978
 Trustee takes over assets, sells them and distributes
the proceeds according to the absolute priority rule
 Reorganization
 Chapter 11 of the Federal Bankruptcy Reform Act of
1978
 Restructure the corporation with a provision to repay
creditors

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 Quick Quiz
 Explain the effect of leverage on EPS and ROE
 What is the break-even EBIT and how do we compute
it?
 How do 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?

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 17

End of Chapter

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 Comprehensive Problem
 Assuming perpetual cash flows in Case II
Proposition I, what is the value of equity
for a firm with EBIT = $50 million, Tax rate
= 40%, Debt = $100 million, cost of debt =
9%, and unlevered cost of capital = 12%?

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